Friday, August 31, 2007

I like this, perhaps because it echoes and provides a foundation for some of
the points I've been making. It's from Melvyn
Krauss, a senior fellow at the Hoover Institution:

Sub-Prime Economic Theory, by Melvyn Krauss, Project Syndicate:
The possibility that the European Central Bank may raise interest rates in the
midst of a financial crisis recalls the great American orator William Jennings
Bryan’s famous “cross of gold” speech in 1896. Referring to the international
gold standard’s deflationary bias, Bryan railed: “You shall not press down upon
the brow of labor a crown of thorns. You shall not crucify mankind upon a cross
of gold.”

In other words, ordinary people should not be made to suffer for the foibles
of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences –
colorfully called a “reduced appetite for risk” – is the key reason behind the
current sub-prime mortgage and financial crisis. To avoid future increases in
this appetite, policymakers and pundits have focused on the so-called “moral
hazard problem”: the “bad guys” must pay for their mistakes, lest they make them
again.

One would have expected the modern-day William Jennings Bryan to be warning
central bankers not to crucify mankind on a “cross of moral hazard and
no-bailouts.” But, surprisingly, the opposite is occurring.

I think everyone should know that you may soon
be subjected to a marketing blitz promoting war with Iran. Like the author of
the post below, I don't know whether this is true or not, but "it’s worth a heads-up":

Greg Ip reports from the Federal Reserve conference at Jackson Hole on the tension between those who believe in
bubbles and those who believe in more traditional explanations of rapid price
escalation:

The Tension Between Traditional Economics and Bubbles, by Greg Ip, WSJ Economics
blog: Economists, in particular those at the Federal Reserve, are
loathe to believe asset markets have become bubbles because bubbles seem
inconsistent with rational investor and consumer behavior, the bedrock of
economic analysis. “The notion of a speculative bubble is inherently
sociological or social-psychological, and does not lend itself to study with the
essential toolbag of economists,” says Yale University’s Robert Shiller in a
paper presented Friday at the Federal Reserve Bank of Kansas City’s research
symposium in Jackson Hole.

Mr. Shiller has made a career out of trying to incorporate irrationality,
psychology and bubbles into economic thinking. His book Irrational Exuberance
was a timely warning on the stock bubble. For some years he has made similar
warnings about the housing market. In his new paper he cites several historic
episodes in which surges in real-estate values coincided with an intensifying
public belief in ever-rising prices: in U.S. houses in the 1950s, in U.S.
farmland in the 1970s.

For the latest decade, he argues that because home prices have so rapidly
outstripped the growth in rent and construction costs, they must be “driven
largely by extravagant expectations for future price increases.”

Yet Mr. Shiller’s paper may not convince skeptics. He does marshal
interesting examples of how popular obsession with real-estate prices coincides
with bubbles. ... He cites surveys he and a colleague conducted in both 1988 and
2006 that found attitudes in Los Angeles about future price gains in that city
were highly correlated with recent history at the time.

But it isn’t surprising that expectations of prices — whether for real
estate, stocks or goods and services — are heavily influenced by the recent
past. The real question is, is that expectation itself an overwhelming factor in
continuing to drive prices yet higher, the essence of a bubble? Perhaps, but he
presents no empirical evidence of that. To be sure, designing an economic
experiment that proves how a state of mind affects economic outcomes is hard.
Perhaps that simply proves Mr. Shiller’s point: proving or disproving bubbles is
still, for now, beyond the ability of mainstream economics.

...a significant factor in this boom was a widespread perception that houses
are a great investment, and the boom psychology that helped spread such
thinking. In arguing this, I will make some reliance on the emerging field of
behavioral economics. This field has appeared in the last two decades as a
reaction against the strong prejudice in the academic profession against those
who interpret price behavior as having a psychological component....

One thing I have never understood is the source of Shiller's confidence that
he is able to rise above these cognitive pitfalls in a way that market
participants can not. Nor does his quantitative evidence help me to understand
his position any more clearly. He notes for example a 1988 survey which found
that the median new homebuyer in Los Angeles expected 11% price appreciation
over the next 12 months, whereas the median buyer in Milwaukee expected only 5%.
Since the OFHEO house price index shows a 13.9% appreciation for Los Angeles and
a 6.2% appreciation for Milwaukee during 1989, it's hard for me to see how these
survey results are supposed to convince us of people's lack of rationality. I
also am unsure how Shiller's concept of real estate price bubbles in "superstar"
cities is to be reconciled with the fact that the problems with mortgage
defaults initially proved to be most serious in rustbelt areas where there had
been very little real estate price inflation. ...

According to the Ludwig von Mises Institute website, this essay "was first
published in 1969. It was one of the last pieces Mises wrote." Here's a few
passages along with the table of contents and links to the full essay (I've been assigned to teach The History of Economic Thought this fall, something I haven't done for quite awhile, and I am going to try to do more on the Austrian school than I've done in the past):

Paul Krugman says the administration may find success through its failures:

Katrina All the Time, by Paul Krugman, Commentary, NY Times: Two years ago
today, Americans watched in horror as a great city drowned, and wondered what
had happened to their country. Where was FEMA? Where was the National Guard? Why
wasn’t the government of the world’s richest, most powerful nation coming to the
aid of its own citizens?

What we mostly saw on TV was the nightmarish scene at the Superdome, but
things were even worse at the New Orleans convention center, where thousands
were stranded without food or water. The levees were breached Monday morning —
but as late as Thursday evening, The Washington Post reported, the convention
center “still had no visible government presence,” while “corpses lay out in the
open among wailing babies and other refugees.”

Meanwhile, federal officials were oblivious. “We are extremely pleased with
the response ... to this terrible tragedy,” declared Michael Chertoff, the
secretary for Homeland Security, on Wednesday. When asked the next day about the
situation at the convention center, he dismissed the reports as “a rumor” or
“someone’s anecdotal version.”

Today, much of the Gulf Coast remains in ruins. Less than half the federal
money set aside for rebuilding ... has actually been spent... On the other hand,
generous investment tax breaks, supposedly designed to spur recovery in the
disaster area, have been used to build luxury condominiums near the University
of Alabama’s football stadium..., 200 miles inland.

But why should we be surprised by any of this? The Bush administration’s
response to Hurricane Katrina — the mixture of neglect of those in need,
obliviousness to their plight, and self-congratulation in the face of abject
failure — has become standard operating procedure. These days, it’s Katrina all
the time.

Consider the White House reaction to new Census data on income, poverty and
health insurance. By any normal standard, this week’s report was a devastating
indictment of the administration’s policies. ... What the data show ... is that
2006, while a good year for the wealthy, brought only a slight decline in the
poverty rate and a modest rise in median income, with most Americans still
considerably worse off than they were before President Bush took office.

Most disturbing of all, the number of Americans without health insurance
jumped. ... Yet the White House ... declared that President Bush was “pleased”
with the new numbers. Heckuva job, economy! ...

The question is whether any of this will change when Mr. Bush leaves office.

There’s a powerful political faction in this country that’s determined to
draw exactly the wrong lesson from the Katrina debacle — namely, that the
government always fails when it attempts to help people..., as if the Bush
administration’s practice of appointing incompetent cronies to key positions and
refusing to hold them accountable no matter how badly they perform — did I
mention that Mr. Chertoff still has his job? — were the way government always
works.

And I’m not sure that faction is losing the argument. The thing about
conservative governance is that it can succeed by failing: when conservative
politicians mess up, they foster a cynicism about government that may actually
help their cause.

Future historians will, without doubt, see Katrina as a turning point. The
question is whether it will be seen as the moment when America remembered the
importance of good government, or the moment when neglect and obliviousness to
the needs of others became the new American way.

The countries are arranged in ascending order of inequality in disposable
income, and the Nordic countries take four of the top five positions. What
strikes me is the extent to which this is due to government policy: the Gini
coefficient for market income in Canada is the same as Denmark's, and is quite a
bit lower than in Sweden. Indeed, Sweden is closer to the US
than it is to any of the other Nordic countries.

A recurrent theme in discussions of the Nordic model takes the form of
"That's all very well, but those policies won't work here without [insert some
feature of Nordic countries here]." Libertarian types who would otherwise
approve of the free market dynamism of the Nordics assert that the Nordic model
can only work in small, homogeneous countries. As a general argument, I'm
not convinced - but I can see why it would be
hard to export the Nordic model to the US.

At the other end of the spectrum - those who would
otherwise approve of Nordic levels of spending on social programs - some (eg:
this commenter) point to the role of trade unions. But it's hard to conclude
from this chart that union density matters much when it comes to reducing
inequality. For example, look at Germany (where unions play a crucial role in
setting wages) and the US (where they are decidedly less important): both have
identical levels of inequality of market income. The distribution of disposable
income is lower in Germany because of its redistributive policies, not because
unions are more powerful.

That's not to say that cross-country institutional/cultural
idiosyncrasies aren't important; they are. But there's little reason to believe
that these factors have to be changed before the Nordic model can work.

Willem Buiter says "the US has become one of the least operationally
independent of the central banks in the industrial world":

A Fed Chairman's lot is not a happy one (happy one), by Willem Buiter:
Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee ...
and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked
more like a Taliban hostage than an independent central banker at his August 21
meeting in Dodd’s office. The letter from Bernanke to Senator Charles Schumer,
circulated around Washington DC on Wednesday August 29, 2007, in which the
Governor of the Federal Reserve offered reassurances that the Federal Reserve
was “closely monitoring developments” in financial markets, and was “prepared to
act” if required, reinforces the sense of a Fed leant upon and even pushed
around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent
central banks since the New Zealand experiment of 1989, the US has become one of
the least operationally independent of the central banks in the industrial
world. Only the Bank of Japan is, I believe, even more readily influenced by
political pressures...

[T]he fact that the Fed is a creature of Congress, and can be abolished or
effectively amended out of existence with simple majorities in both Houses, has
acted as a significant constraint on what the Fed can do and say. ...

To illustrate the difference between the degree of operational independence
of the Fed and the ECB, consider the inflation target. The ECB has price
stability as its primary target. Without prejudice to price stability, it can
pursue all things bright and beautiful, and is indeed mandated to do so. All
this is in the Treaty. There is, however, no quantitative, numerical inflation
target in the Treaty. Nor does the Treaty spell out which institution should set
such at target, if there were to be one. So the ECB just went ahead and declared
that an annual inflation rate of just below but close to 2 percent per annum on
the CPI index, would be compatible with price stability. Neither the European
Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the ... goals of monetary
policy. ... Could the Fed do what the ECB did, and specify a numerical inflation
target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult
than that of the ECB or even the Bank of England. Strong Chairmen, like Paul
Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than
a weak Chairman like Alan Greenspan, but even the most independent-minded and
strong-willed Fed Chairman is much more subject to political influences and
constraints than the President of the ECB or the Governor of the Bank of
England.

Both populism and special interest representation are key driving forces in
the US Congress. Preventing large numbers of foreclosures on madcap home
mortgages taken out especially since 2003, unites the forces of populism and
special interest representation, although they tend to part company when it
comes to who will pay the bill for the bail-out. ...

Policy rate cuts are justified if and only if the legally mandated objectives
of the monetary authority require it. ... Credit crunches and liquidity crises
therefore matter only to the extent that they affect these ... goals, now or in
the future. Fortunately, instruments exist with which credit squeezes and
liquidity crises can be addressed effectively, and without creating moral hazard
(such as the MMLR at punitive prices described above) that do not involve
changing the monetary policy rate.

I hope and expect that if and when the Fed perceives that real economic
activity is likely to weaken materially going forward and/or that inflation is
likely to undershoot its comfort zone ..., rates will be cut decisively and
without delay.

I also fear and expect that, because of the relentless pressure being brought
to bear on the Fed by all branches of the Federal Government (with the
exception, as far as I know, of the Supreme Court), the Fed will be convinced to
cut the Federal Funds target rate, probably as soon as the September meeting. I
fear this could be not because this is the best way to guarantee the optimal
trade-off between its three macroeconomic goals, but because this is the only
way to salvage some measure of future independence for the Fed, in the face of
irresistible pressure for a cut now from a lobby for a lower Federal Funds rate
that includes special interests ranging from low income households unable to
service their wildly inappropriate mortgages to extremely high net worth hedge
fund managers facing massive losses and early retirement.

I hope I’m wrong on the last point.

Just one comment. In the US, the intent is not for the Fed to be completely
politically independent, there are mechansims in place that allow various
political interests be represented in the deliberations over monetary policy.
Though power has been centralized over time so that some of these mechansims are
now relatively weak, the set up of the system tries to ensure that banking,
business, and the public interests are repersented on the monetary policy committee, that power is
distributed geographically, and the structure is such that the executive branch
has political influence over the chair of the Fed (e.g. four year terms).
Whether or not this is the best way to set up the central bank is something
to consider - I favor more independence than we have now - but the fact that
there is political influence and representation is not at odds with the design of the Federal Reserve system.

Thursday, August 30, 2007

Here's a follow-up that reinforces some of the points I have been making. I
could have saved a lot of ink by simply posting this. The only comment I have is
that I am not quite as certain as he is that the crisis is, and will continue to be, contained:

An extensive but benign
crisis?, by Tommaso Monacelli, Vox EU: The public and (especially) the press
seem to have overreacted to the current turmoil in financial markets. ...
However, if it is a financial turmoil that we are facing, it is most likely to
involve an “extensive/benign” scenario rather than an “intensive/malign”
scenario. An extensive/benign scenario is one in which a specific and
quantitatively limited type of risk ... is spread out extensively across
investors and countries for risk-sharing purposes (the benign phenomenon) via
the instruments of financial diversification. An intensive/malign scenario, by
contrast, is one associated with a large amount of risk concentrated with some
investors (possibly geographically), whose deterioration usually leads to large
default losses (the malign phenomenon).

In the last twenty years, financial markets have changed dramatically... This
has been synonymous with increased ability of risk diversification. ... The
physical link between the primary borrower (the family seeking a mortgage) and
the lender, via a plethora of instruments of financial diversification..., has
weakened considerably. At the same time, technological improvements in the risk
assessment process have substantially reduced monitoring costs for lenders.

In this context, the fact that lenders (loosely speaking) have been assuming
an increasing amount of risk (“the subprime loans”) is a natural implication of
the deepening of financial diversification. In the specifics of mortgage
markets, home-ownership projects that were turned down ten years ago have now
become eligible for finance. With falling monitoring costs and increased ability
of diversification, financing riskier categories of borrowers can be perfectly
consistent with profit maximisation by lending institutions. On the other hand,
for previously constrained families, this process of financial diversification
has meant a loosening of their borrowing constraints. Overall, and from the
viewpoint of economic theory, it is hard to identify this as a malign
phenomenon.

It is sometimes argued that, along the financial diversification chain, it
may become increasingly difficult to identify where the risk exactly lies.
Certainly true, yet isn’t this exactly what financial diversification is all
about? ...

From a different angle, many critics have pointed out ... “excessive lending”
or “excessive amount of risk” as necessary drawbacks of increased financial
diversification. From the standpoint of economic theory, though, “excessive” is
meaningful only if “inefficient”. In this case, one can formally identify an
inefficiency if either of two phenomena arises: (i) an increased “adverse
selection” and/or (ii) an increased “moral hazard” problem. Possibly, only the
latter qualifies as concrete in this context.

Adverse selection and moral hazard

Isn’t it worrying that ... “nowadays nobody is denied a mortgage”, virtually
any family – including the most risky ones – decides to show up in a bank and
ask for a loan? Not really, to the extent that the risk associated to this
borrower is priced correctly (with this being more likely as monitoring costs
fall) and is diversified through the system. After all, once again, this is what
financial risk-sharing is all about.

Poor president Bush. Victor Davis Hanson is upset because nobody, but nobody
likes the president, except, apparently, him. He argues that the critics have it
wrong, that the president deserves some respect for his dogged pursuit of Osama
Bin Laden and his followers. Is he serious? Credit for the pursuit of Bin
Laden?:

However venomous this current Democrat attack machine, it is somewhat similar
to what Republicans did to Bill Clinton in the 1990s. That's what
rough-and-tumble two-party politics is about. Of course, there are even Bushophobes among Republicans and right-wingers.

Ultra-conservatives don't like open borders or the president's big increases
in federal spending. As neo-isolationists, they don't think Iraq is worth one
dead Marine. Now even mainstream Republicans are inching away...

Overseas, the president continues to get no love. ... Arab reformers aren't
fans of the president, either...

Finally, there is at least one group whose hatred of Bush is more than
welcome: bin Laden and his al-Qaida terrorists. ... But why ... does bin Laden
hate George Bush so passionately? ... Al-Qaida terrorists no doubt hate every American president. But bin Laden's
venom for feisty George Bush is special, galvanized by the president's
success...

I'm not sure where I'm headed with this, so I am going to do something I
don't usually do and just start writing. Hopefully, I'll find a point along the way. Vaguely, I want to connect "bubbles" to the invisible hand concept identified with Adam Smith, i.e. to the process that moves resources to their most efficient uses. [...continue...]

Greg Ip says that, unlike Alan Greenspan, Ben Bernanke draws a clear
distinction between financial market instability and instability in the overall economy and this gives him a different approach to policy:

That shift is important in understanding why Mr. Bernanke hasn't cut the
Fed's main interest rate yet, and it could alter investors' expectations of how
the Bernanke Fed will function. The Fed historically has had two major economic
duties. Maintaining financial stability is one. Controlling inflation while
preventing recession is the other.

To Mr. Greenspan, market confidence and the economy's growth prospects were
so intertwined as to make the Fed's two duties almost inseparable. He cut rates
after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term
Capital Management in 1998...

By contrast, Mr. Bernanke distinguishes between the central bank's two
functions. So, on Aug. 17, the Fed ... action was aimed at restoring the normal
functioning of disrupted credit markets, not primarily at boosting growth. The
Fed, meanwhile, hasn't cut the far more economically important federal-funds
rate...

To be sure, all central bankers see a link between financial and economic
stability. ... But, "There's no doubt they were trying to draw a distinction
between using the main tool of monetary policy, which is the federal-funds rate,
and aiming the discount rate at restoring the plumbing," says Alan Blinder, a
former Fed vice chairman.

To be sure, if Mr. Bernanke eventually cuts the federal-funds rate, as
markets anticipate, the contrast with Mr. Greenspan will be less sharp. Mr.
Bernanke will elaborate on the outlook tomorrow at the Federal Reserve Bank of
Kansas City's annual symposium in Jackson Hole, Wyo. ...

Mr. Bernanke's approach to the credit crunch is, in part, an effort to undo
perceptions fostered by Mr. Greenspan's rate-cutting interventions. Though
successful, they drew allegations of "moral hazard" -- that is, of encouraging
investors to act more recklessly because they think the Fed will protect them.

Neither Mr. Bernanke nor his closest colleagues ... believe there ever was a
"Greenspan put," a reference to a contract that protects an investor from loss.
Yet officials acknowledge the perception that the Fed has bailed out investors
in the past. ...

Mr. Bernanke may yet have to cut rates. But the longer he waits, the more
likely he can break investors of the assumption that market convulsions lead to
interest-rate cuts. ...

If Bernanke has a similar emphasis in his remarks tomorrow, will expectations
for a rate cut shift? As mentioned earlier, it will be interesting to see if there is any attempt to
soften the widely held expectation that rates will be cut at the next meeting.

With the Fed supplying funds to relieve the sudden cash crunch, investors
have had time to begin to distinguish good credits from bad. As a result, large
portions of the market have begun to normalize.

That's good news for Fed officials, because it's clear they would prefer not
to lower their 5.25 percent target for the overnight lending rate. And they
certainly have no intention of doing so before the Sept. 18 meeting...

The normalization process, which has a long way to go, is even occurring in
the market for mortgage-backed securities. ...

The effective overnight lending rate has moved close to the 5.25 percent
target after Fed injections of cash kept it well below that level for most of
two weeks. Treasury bill yields, which had plunged in the middle of this month,
have bounced up by more than a percentage point.

And this improvement has come against a background of lessening concern that
a major U.S. financial institution might be brought down by losses related to
subprime mortgages. Banks are going to take a hit on earnings, not anything more
than that.

Economist Paul Ashworth of Capital Economics in London said yesterday that
the Fed now faces a dilemma over what to do about the lending-rate target.

''The markets have a 25 basis point cut fully priced in for the meeting on
Sept. 18 and anticipate further cuts after that,'' Ashworth said. ''But equity
and credit markets have begun to normalize...

''The recovery means that the immediate need to cut the Fed funds rate has
receded. If the Fed fails to deliver a rate cut, however, markets could go into
a tailspin again,'' Ashworth said.

Another Tailspin? Would they? ...

Markets are likely to remain volatile regardless of the outcome of the
meeting, and officials aren't going to let that fact sway their decision.

What will matter most -- ... assuming no new credit- market meltdown -- will
be their assessment of how much the economic outlook has changed.

In a statement issued Aug. 17, the committee said that because of the big
change in financial market conditions ''the downside risks to growth have
increased appreciably.'' So already the FOMC had swung from emphasizing the risk
that core inflation would not moderate as expected to worrying about slowing
growth.

Among the risks, of course, are that the problems in the housing market,
including falling home prices, and declining stock prices will hurt consumer
spending. Consumer confidence is dropping after all.

On the other hand, employment is still rising, as are wages, and when
household incomes go up, spending usually does.

Just as the earlier concern about core inflation didn't trigger a rate
increase, shifting to concern about growth doesn't mean a rate cut is
foreordained. ...

Nothing about the choice on Sept. 18 will be simple. Nor will be the full
normalization of credit markets. ...

I still don't think the Fed will make a move contrary to expectations, and as of now a rate cut is widely expected, so it will be interesting to see if there are any signs that Ben Bernanke is trying to shift those expectations in his speech later today.

Because my approach to election issues tends to be more closely aligned with
Democrats, I was paired with a Republican co-author. To further remove any taint
of partisanship, my co-author and I convened a bipartisan working group to help
us. We spent a year doing research and consulting with leaders in the field to
produce a draft report. What happened next seems inexplicable. After submitting
the draft in July 2006, we were barred by the commission's staff from having
anything more to do with it. ...

In all the time we were doing our research and drafting the report, neither
the staff nor the commissioners, who were continually advised of our ... work,
raised any concerns...

Yet, after sitting on the draft for six months, the EAC publicly released a
report -- citing it as based on work by me and my co-author -- that completely
stood our own work on its head.

Consider the title. Whereas the commission is mandated by law to study voter
fraud and intimidation, this new report was titled simply "Election
Crimes" and excluded a wide range of serious offenses that harm the system and
suppress voting but are not currently crimes under the U.S. criminal code.

We said that our preliminary research found widespread agreement among ...
experts from all points on the political spectrum that allegations of fraud
through voter impersonation at polling places were greatly exaggerated. ... The
commission chose instead to state that the issue was a matter of considerable
debate. And while we found that problems of voter intimidation were still
prevalent in a variety of forms, the commission excluded much of the discussion
of voter intimidation.

We also raised questions about the way the Justice Department was handling
complaints of fraud and intimidation. The commission excised all references to
the department that might be construed as critical -- or that Justice officials
later took issue with. And all of the suggestions we received from political
scientists and other scholars regarding methodologies for a more scientifically
rigorous look at these problems were omitted. ...

What was behind the strange handling of our report? It's still unclear, but
it is worth noting that during the time the commission was holding our draft,
claims about voter fraud and efforts to advance the cause of strict voter
identification laws were at a fever pitch in Congress and the states. And it has
been reported that some U.S. attorneys were being fired because they failed to
pursue weakly supported voter fraud cases with sufficient zeal.

We have learned that several Republican officials, including a state
official, a former political appointee at the Justice Department and current
Federal Election Commission member (Hans Von Spakovsky), and a Capitol Hill
staffer complained about our project, particularly about my role in it.
Officials at Justice were actively involved in the report throughout ... and
even exerted some degree of editorial control... And it is evident from the
commission's "document dump" that its Republican general counsel assumed primary
control over the rewriting of the report. ...

This is not the way an institution created to promote democracy should
function. A government entity that seeks democratic progress should be
transparent. It should not be in the business of suppressing information or
ideas. Such an institution must be thoroughly insulated from political
interference from outside operatives or other parts of the executive branch.

We need an institution like the Election Assistance Commission to provide
guidance and research information to the states, election officials, elected
leaders and voters. But this agency's structure and procedures need to be
seriously reexamined in light of this episode...

Wednesday, August 29, 2007

Is Labor Day anything more to you than a long weekend, if it's
even that? Will you be taking a moment to reflect on
the "social and
economic achievements of American workers"?:

What Happened to Labor Day?, by Robert Reich: ...Most young people today
have no memory of a time when Walter Reuther of the UAW and John L. Lewis of the
United Mine Workers were household names, ... when productivity gains pushed
wages up, and when more than a third of the American workforce was unionized.

Now fewer than 8 percent of America's private sector workers are in unions,
median wage gains have fallen far behind productivity gains, and for most of us
Labor Day means a long weekend.

What happened? Some say it started in the early 80s after Ronald Reagan fired
the nation's air-traffic controllers for striking - something they had no legal
right to do - and thereby legitimized a wave of corporate union busting. Others
blame it on a more pervasive "greed is good" aggressiveness that engulfed
corporate suites starting right about then. ...

But don't blame Ronald Reagan or corporate greed. Blame us - you and me. You
see, starting about 30 years ago and with increasing efficiency, technologies
have given us consumers a world of choice - low priced goods and services that
often depend on low wages here and elsewhere. ...

In other words, we as a nation have traded off lower priced goods and
services, in place of a unionized workforce with the bargaining clout to get
higher wages. So now, a lot of us get good consumer deals and lousy paychecks.

No one trumpeted this choice. It's happened gradually. But is it the right
choice? That's what we ought to be asking ourselves -- at least once a year, on
Labor Day.

"But don't blame Ronald Reagan or corporate greed." To explain the decline of
unions, do we only get to choose one item from the list, or can we also cite, say,
Reagan too? My choice is all of the above.

The WSJ Economics blog
notes this paper from the San Francisco Fed on the usefulness of the yield
curve as an indicator of coming recessions. It may be more useful than we thought:

Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve, by
Glenn D. Rudebusch and John C. Williams, July 2007: Abstract We show
that professional forecasters have essentially no ability to predict future
recessions a few quarters ahead. This is particularly puzzling because, for at
least the past two decades, researchers have provided much evidence that the
yield curve, specifically the spread between long- and short-term interest
rates, does contain useful information at that forecast horizon for predicting
aggregate economic activity and, especially, for signalling future recessions.
We document this puzzle and suggest that forecasters have generally placed too
little weight on yield curve information when projecting declines in the
aggregate economy.

Here's more from the introduction:

1. Introduction The word "recession" conjures a variety of fears --
for workers who suffer job losses, for investors who endure asset price
declines, for entrepreneurs who risk bankruptcy. Recessions are periods of
greater dislocation and anxiety, higher unemployment and suicide rates, and
lower output and profits. In the United States, recessions have become less
frequent and less severe in the past two decades; however, non-recessionary
episodes have also become more stable, so in relative terms, as the market
sensitivity in the epigraph suggests, recessions appear to many to be as
perilous as before. Therefore, any ability to predict recessions remains highly
profitable to investors and very useful to policymakers and other economic
agents. Accordingly, there remains a keen and widespread interest in predicting
recessions, and our paper examines what economic forecasters know about the
likely occurrence of a recession and, most importantly, when do they know it.

Systems of actual socialized medicine, like Britain's, are actually very good
at saying no: there's a limited budget, and the medical professionals who run
the system set priorities. That's the reason British health care delivers
results better than ours, at only 40 percent the cost — there are long waits for
elective surgery, but that's because doctors think that it's not a high
priority...

Krugman gets points for a
mostly honest description but he is a lousy salesman. Is there any doubt that
most people reading this will say "no way, not in America."?

If we look at just one statistic rather than comparing the systems overall,
then we can get a distorted picture. Suppose you are in Britain, Canada, France.
etc. and you are debating whether to adopt a market-driven system. Though the
U.S. is far from a pure market-driven system, something often overlooked
in these discussions, when you do look at the U.S. and find out that waiting
times for cosmetic surgery are longer shorter than for medically necessary care, is that the kind of
market-driven priorities you want in the system?:

“The difference in wait times between medical dermatology and cosmetic
dermatology patients is clearly real,” said Dr. Jack S. Resneck Jr., the lead
author of the study... In Boston, the median Botox wait was 13 days, versus 68 days for a mole
examination. ...

On Poverty, Maybe We're All Wrong, by Steven Pearlstein, Commentary, Washington
Post: ...As it happens, each spring the Census Bureau gets around to
computing an alternative after-tax measure of disposable income that includes
... various tax and transfer programs... This supplemental report gets little
attention, but the adjustments are ... significant. In 2005, for example, they
dropped the poverty rate from 12.6 percent to 10.3 percent, with the biggest
improvement coming in a four-percentage-point reduction in child poverty.

At the same time, these revisions help put the lie to the right-wing conceit
that government tax and transfer policies only make poverty worse. Conservatives
are left to fall back on the argument that government handouts and social
insurance programs, while appearing to lift some out of poverty, have created a
permanent underclass by discouraging work and thrift and fostering a culture of
dependence.

Much better, conservatives say, to do away with all those patronizing and
inefficient social welfare schemes that create perverse incentives and "empower"
the poor to act in their own best interest using the same traditional market
mechanisms as everyone else.

The best refutation of this argument that I've seen in a long time is
contained in a new book, "The Persistence of Poverty," by ... Charles "Buddy"
Karelis ... at George Washington University. Karelis isn't an economist or
social welfare expert but a philosopher... And after doing lots of reading and
giving it extensive thought, Karelis concluded that the reason ... the poor are
poor is that they are more likely to not finish school, not work, not save, and
get hooked on drugs and alcohol and run afoul of the law. Liberals tend to blame
it on history (slavery) or lack of opportunity (poor schools, discrimination),
while conservatives blame government (welfare) and personal failings (lack of
discipline), but both sides agree that these behaviors are so contrary to
self-interest that they must be irrational.

After all, the reason we study, work, save and generally behave ourselves is
that these behaviors allow us to earn more money, and more money will improve
our lives. And, by logic, that must be particularly true of the poor, for whom
each extra dollar to be earned or saved for a rainy day is surely more valuable
than it is for, say, Bill Gates. ...

But what if this iron law of economics is wrong? What if it doesn't apply at
every point along the income scale? If you and everyone around you are
desperately poor, maybe it's perfectly rational to think that an extra dollar or
two won't make much of a difference in reducing your misery. Or that you won't
be able to "study" your way out of the ghetto. Or that if you find a $100 bill
on the street, maybe it's logical to blow it on one great night on the town
rather than portion it out a dollar a day for 100 days.

On the other hand, maybe the point at which people are most willing to work
hard, save and play by the rules isn't when they are very poor, or very rich,
but in the neighborhoods on either side of ... a motivational sweet spot that,
in statistical terms, might be defined as between 50 percent ($24,000) and 200
percent ($96,000) of median household income. And if that is so, then maybe the
best way to break the cycle of poverty is to raise the hopes and expectations of
the poor by putting them closer to the goal line.

Admittedly, this is only a theory, supported by logic and anecdote. But if
Karelis is right, it could provide a solid economic argument to replace the old
moral ones for spending more money on programs like food stamps, subsidized
child care and the earned income tax credit...

Do we need new arguments? I can come up with economic arguments to justify
intervention as it is (e.g. market failures), so we don't have to rely on purely
normative arguments. And whether the model is true or not, I don't see how it changes the morality anyway. All
it does is change the shape of a function to something resembling an inverted
u-shape. That is, it doesn't say the government should intervene, it only
specifies the form of the intervention should the government wish to do so.

The request -- which would come on top of about $460 billion in the fiscal
2008 defense budget and $147 billion in a pending supplemental bill to fund the
wars in Afghanistan and Iraq -- is expected to be announced after congressional
hearings scheduled for mid-September featuring the two top U.S. officials in
Iraq. Army Gen. David H. Petraeus and Ambassador Ryan C. Crocker will assess the
state of the war and the effect of the new strategy the U.S. military has
pursued this year.

The request is being prepared now in the belief that Congress will be
unlikely to balk so soon after hearing the two officials argue that there are
promising developments in Iraq but that they need more time to solidify the
progress they have made, a congressional aide said. ... The decision to seek
about $50 billion more appears to reflect the view in the administration that
the counteroffensive ... will not be shortened by Congress. ...

The revised supplemental would total about $200 billion, indicating that the
cost of the war in Iraq now exceeds $3 billion a week. The bill also covers the
far smaller costs of the war in Afghanistan. ...

In a speech yesterday to the convention of the American Legion in Reno, Nev.,
Bush gave an optimistic assessment of recent events in the war, now in its fifth
year. "There are unmistakable signs that our strategy is achieving the
objectives we set out," he said. "The momentum is now on our side."

Yes, Mission Nearly Accomplished -- we've heard that before. Since the administration line that "the surge is working, it just needs more
time" is being reported uncritically, here's more:

These and other developments take us back in some ways to December 2006. It
was then, in the wake of the November election and the report of the Iraq Study
Group, that the debate in Washington finally appeared to be shifting away from
how to achieve victory and toward how to cut our losses.

Instead, Bush ignored public sentiment, overruled his military commanders and
opted for escalation. And now it appears that the only thing the surge has bought him is time --
nine months or maybe a year, during which he was able to postpone the
inevitable.

What has that year cost America -- and Iraq? For starters, a year in Iraq
translates to over 1,000 more dead American soldiers; over $100 billion more in
direct appropriations; over 15,000 more dead Iraqi civilians; and countless
grievous wounds and shattered families both here and there.

In light of the costs, having bought a year of time may not seem like much of
an accomplishment. But if Bush can drag things out another year or so, he can
wash his hands of the whole mess and leave it for his successor to deal with...

Warren P. Strobel and Leila Fadel write for McClatchy Newspapers: "A new
assessment of Iraq by U.S. intelligence agencies provides little evidence that
the American troop 'surge' has accomplished its goals and predicts that the
U.S.-backed government of Prime Minister Nouri al-Maliki will become 'more
precarious' in the months ahead.

"A declassified summary of the report released Thursday said that violence
remains high, warns that U.S. alliances with former Sunni Muslim insurgents
could undercut the central government and says that political compromises are
'unlikely to emerge' in the next 12 months."

Mark Mazzetti writes in the New York Times: "The assessment, known as a
National Intelligence Estimate, casts strong doubts on the viability of the Bush
administration strategy in Iraq. It gives a dim prognosis...

One of the main reasons for the troop surge was to allow for a political
reconciliation, and that hasn't happened. So, in essence, the argument is that
the strategy hasn't worked, so we need to do more of it.

Tuesday, August 28, 2007

Some of you might be tired of hearing about mortgage markets, financial
crises, how the Fed should react, etc., so here's something different:

New research suggests that the US incentive system built around test scores
almost guarantees that academically disadvantaged children do not benefit and
may actually be harmed. Policy-makers should take incentive design issues more
seriously or follow the lead of many private sector firms and look for other
ways to monitor and motivate teachers.

Here's the write-up of the research:

Many U.S. Children are
Left Behind by Design, by Derek Neal and Diane Whitmore Schanzenbach, Vox EU:
Roughly two decades ago, education policy makers in the United States began to
rely more heavily on standardized test scores as performance metrics for
teachers and schools. During the late 1980s and through the 1990s, many states
adopted test-based accountability systems that spelled out rewards and sanctions
for teachers and principals as a function of the performance of their students
on standardized tests, and when the federal government adopted the No Child Left
Behind Act (NCLB) of 2001, test-based accountability became a nation-wide
policy. The proponents of this development cite the need to bring "business
practices" into public schools and the need to make schools "data driven" in
ways that mirror the practices of private-sector companies.

Imagine living a world with no insurance, there's no health insurance, fire
insurance, auto insurance, unemployment insurance, Social Security, nothing of
this sort at all. As we know from countries such as China, when insurance is not
widely available households tend to increase their savings, i.e. to increase
their precautionary saving balances.

But in a world with insurance, consumers are able to reduce these precautionary savings
considerably. In doing so, they can be more exposed to risk from large shocks. If you are
relying upon your insurance company to pay for the loss if your house burns
down, your car is wrecked, or you have a costly health problem, etc., and hence have not left sufficient available liquidity to cover these contingencies yourself,
and if the insurance company does not pay off as expected, things could be pretty
tough. With insurance, people do not leave as much margin for error along a lot of
fronts, they reduce their precautionary balances, and failure of an insurance company to payoff as expected could cause severe
financial distress, distress that might not have occurred without the dependence on insurance.

This is different than another way of increasing risk, moral hazard. If I get
fire insurance, I can reduce my precautionary balances as described above, and
this leaves me more exposed than before if the insurance company fails. But if I
then start to use real candles on my Christmas tree, don't bother
to get the fireplace cleaned, don't bother to clear the dry brush around the house, etc., then that is moral hazard.

Moral hazard is a form of market failure and, as such, we need to avoid it.
One way is not to provide insurance at all. No insurance, no moral hazard,
simple. But there are other ways of dealing with the problem that can reduce its
negative effects without causing us to give up on providing insurance. For
example, co-payments and deductibles are both ways of reducing moral hazard. The
idea is to make the insured pay part of the cost when there is a payout so that they will reduce the
incidence of avoidable risks.

Turning to mortgage and financial markets, I see nothing at all wrong with
participants in those markets expecting the Fed to stabilize the macroeconomy.
In essence, the Fed is providing insurance against volatility in the overall
economy and of course traders are going to anticipate that if the economy turns
downward, the Fed will adjust rates. They should expect that and take it into account in their decisions.

But just as with regular insurance, this can induce moral hazard and that
seems to be what most of the discussion surrounding whether the Fed should
intervene is about - by providing the insurance to the macroeconomy does the Fed also provide the
motivation for moral hazard behavior (excessive risk taking)?

There is that chance, and likely that reality, but just as with regular
insurance the solution is not to withhold coverage, i.e. for the Fed to do
nothing in the face of an apparently weakening economy to avoid creating poor incentives going forward. We know a lot about how
to solve moral hazard problems and there's no reason at all those cannot be
applied to these markets to reduce this problem.

When necessary, the Fed needs to intervene to stabilize the macroeconomy,
moral hazard or not. Just as you would anticipate your insurance company paying
off if there was a fire, and just as you might face bankruptcy if it did not pay,
participants in financial markets anticipate the Fed will provide insurance to
the macroeconomy (as it always does), and they may face financial difficulties
if it does not.

There's nothing wrong with financial market participants expecting a stable
environment, and reducing their precautionary balances (e.g. their cash
positions) in response just as you would reduce your precautionary saving. It's
the moral hazard part we want to avoid and, as I noted above, there are many,
many ways to intervene into these markets to reduce market failure from moral
hazard in the future, and those can and should be applied whether the Fed intervenes now or not.

There is an exception to when insurance should pay off, of course, and that is
if (for example) you willfully burn down your own house. I want to be careful
here. If I have insurance, and a behavior is not ruled out and it causes a
payoff, I have not crossed any moral lines, I have simply acted according to the
economic constraints that are in place. If there's no deductible on my auto
insurance and no co-pay, if everything is 100% covered, then I won't be so
careful about how I park or about getting small dents, etc., they're covered. If
the insurance company's customers then take excessive risks, and payouts are so
high that the insurance company crashes, that is not the customers fault. The incentives
need to be fixed to make the insurance viable.

Did participants in mortgage markets do the equivalent of burning down their
own houses, or were they simply acting according to the constraints the
insurance company (i.e. the Fed) had in place? I'm sure there were some who set
the place afire themselves, but I believe the preponderance were simply behaving
according to the rules of the game.

Payoff now, as promised, i.e. stabilize the economy if needed and don't worry
about who gets bailed out in the process (but prosecute the arsonists). It may
look like a big bailout, the Fed may have to intervene before signs of problems
in the overall economy are evident due to lags in monetary policy, but there
should be no hesitation about intervening to stabilize economic conditions.

We need to fix the markets so that the incentive to engage in moral hazard type behavior in
the future is substantially reduced, no doubt about it. But what we shouldn't do
is withhold insurance altogether just because we are worried about creating moral hazard
problems in the future. That's not the best way to fix the problem.

We don't just want to prevent people from taking excessive risks; we also want to encourage people to take appropriate risks. In fact, the latter is what we mostly want to do: Because risk often cannot be sufficiently diversified, the risk-takers experience personal costs of failure that are not matched by the social costs.

Update: Martin Wolf and Robert Reich discuss the same issue. Martin
Wolf first:

Such panic-driven politicisation is almost certain to lead to both
overreaction and the creation of bad precedents. What then would be the right
response to this latest scrape that supposedly sophisticated financial markets
have fallen into?

I want to make a simple point in response to so many people calling for heads
to roll over the turmoil in financial markets, and to suggestions that the Fed should not cut rates if doing so bails out financial markets and prevents participants from fully realizing the costs associated with past behavior.

Recessions, popped bubbles and the like do not have to be somebody's fault and, as such, we don't necessarily
have to extract blood from anyone to avoid it happening again. Perfectly
reasonable actions a priori - in the sense of responding to the economic
incentives that are in place - can still lead to bad ex-post outcomes. The
people acting in the economic environment didn't write the rules, they're simply maximizing given the rules that are in place, so why punish them?

I don't mean to absolve those who committed fraud, etc., nor do I mean to absolve those who did fall down on the job - the rule makers
and the ratings agencies - from any responsibility for the outcome. But I doubt that the people writing the rules intended to cause a meltdown, and it's possible they
did the very best they could with the information they had. And it can be
argued, credibly, that ratings agencies simply responded to the economic
incentives that were in place (i.e. responded as expected to being paid by those
they were rating).

We made mistakes in the regulatory environment, no doubt about it, and I hope we learn and fix the problems, but this Victorian call
for someone to pay the price if there are problems seems overwrought, and it's
getting in the way of talking about how to help people.

Here's something by Paul Krugman on this issue that I've posted before, and
is worth repeating:

The Hangover Theory,
by Paul Krugman: A few weeks ago, a journalist devoted a substantial part of
a profile of yours truly to my failure to pay due attention to the "Austrian
theory" of the business cycle--a theory that I regard as being about as worthy
of serious study as the phlogiston theory of fire. Oh well. But the incident set
me thinking--not so much about that particular theory as about the general
worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism,"
or just call it the "hangover theory." It is the idea that slumps are the price
we pay for booms, that the suffering the economy experiences during a recession
is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy
way out, but because it doesn't. It turns the wiggles on our charts into a
morality play, a tale of hubris and downfall. And it offers adherents the
special pleasure of dispensing painful advice with a clear conscience, secure in
the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover
theory is disastrously wrongheaded. Recessions are not necessary consequences of
booms. They can and should be fought, not with austerity but with
liberality--with policies that encourage people to spend more, not less. Nor is
this merely an academic argument: The hangover theory can do real harm.
Liquidationist views played an important role in the spread of the Great
Depression--with Austrian theorists such as Friedrich von Hayek and Joseph
Schumpeter strenuously arguing, in the very depths of that depression, against
any attempt to restore "sham" prosperity by expanding credit and the money
supply. And these same views are doing their bit to inhibit recovery in the
world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the
beginning, an investment boom gets out of hand. Maybe excessive money creation
or reckless bank lending drives it, maybe it is simply a matter of irrational
exuberance on the part of entrepreneurs. Whatever the reason, all that
investment leads to the creation of too much capacity--of factories that cannot
find markets, of office buildings that cannot find tenants. Since construction
projects take time to complete, however, the boom can proceed for a while before
its unsoundness becomes apparent. Eventually, however, reality
strikes--investors go bust and investment spending collapses. The result is a
slump whose depth is in proportion to the previous excesses. Moreover, that
slump is part of the necessary healing process: The excess capacity gets worked
off, prices and wages fall from their excessive boom levels, and only then is
the economy ready to recover. ...

The hangover theory ... turns out to be intellectually incoherent; nobody has
managed to explain why bad investments in the past require the unemployment of
good workers in the present. Yet the theory has powerful emotional appeal.
Usually that appeal is strongest for conservatives, who can't stand the thought
that positive action by governments (let alone--horrors!--printing money) can
ever be a good idea. Some libertarians extol the Austrian theory, not because
they have really thought that theory through, but because they feel the need for
some prestigious alternative to the perceived statist implications of
Keynesianism. ... But moderates and liberals are not immune to the theory's
seductive charms--especially when it gives them a chance to lecture others...

We
don't need a recession. If the Fed determines an interest rate cut is
needed to keep the economy moving toward full employment, then it shouldn't hesitate to implement the policy because it believes it
would send the wrong signal to financial market participants. I hope we don't
get so caught up in our zeal to make sure people learn the right lessons from all of this that we
allow "bad investments in the past" to bring about "the unemployment of good
workers in the present."

We are all uninsured now, by Laurence J. Kotlikoff, Commentary, Boston Globe:
Big numbers, like 45 million uninsured Americans, are hard to grasp. But ... the
rest of us with health coverage are also uninsured. We too face terrible, albeit
more remote, healthcare risks -- the risk that our employer will drop our plan,
that Medicare will go bust, that our plan won't cover our needs, that premiums
will eat us alive, that our doctor will stop taking our insurance, that
long-term care will wipe us out, and that our uninsured friends and family
members will need major financial help.

These risks are entirely avoidable. We can have an efficient, transparent
system that includes everyone; treats everyone fairly; covers all the basics,
including prescription drugs, home healthcare, and nursing home care; and costs
little more than what we now spend. But we can't get there via the piecemeal
reforms that President Bush, most of his would-be successors, and our state
governors are advocating.

Bush first pushed health savings accounts -- a knuckle-brained scheme to get
the uninsured to save for all their healthcare costs short of catastrophic care.
When that didn't stop 5 million more Americans from becoming uninsured, the
president proposed letting the uninsured deduct the cost of their health plans
if they buy private coverage ..., but it won't help much. Most of the uninsured
are in too low a tax bracket or pay too little in taxes for it to make any
difference. ...

Most of the Democratic and several of the Republican presidential candidates
... end game would be a balkanized healthcare system with the old in Medicare,
the poor in Medicaid, most workers in employer plans, and the losers -- the
otherwise uninsured -- in highly subsidized, limited-coverage plans. Loser
plans.

This won't work. First, Medicare and Medicaid are already on a course to
bankrupt the nation. Keeping these programs intact is fiscal suicide. Second,
many employers are fed up with healthcare spending and are heading for the exit.
... And the more attractive loser insurance becomes, the quicker employers will
drop their plans.

Third, loser insurance requires a major federal bureaucracy (think
Hillarycare) and unaffordable subsidies. Fourth, this "solution" does nothing to
reduce the administrative costs that consume a fifth of our healthcare dollars.
Fifth and most damning, making loser policies available doesn't guarantee their
purchase. Millions will remain uninsured.

My solution is called the Medical Security System. It would eliminate
Medicare, Medicaid, and (by dropping the tax breaks) employer-based healthcare.
The government would give everyone a voucher each year for a basic health plan.
The size of the voucher would be based on one's health status. Those in worse
health would get bigger vouchers, leaving insurers no incentive to cherry-pick.
Furthermore, insurers would not be permitted to refuse a voucher or otherwise
deny coverage.

The government would set the total voucher budget as a fixed share of gross
domestic product and determine what a basic plan must cover. We would choose our
own health plans. If we cost the insurer more than the voucher, he would lose
money. If we cost him less, he would make money. Insurers would compete for our
business and could tailor provisions, like co-pays and incentives to stop
smoking, to limit excessive use of the healthcare system and encourage healthy
behavior.

Nothing would be nationalized. Virtually all of the cost would be covered by
redirecting existing government healthcare expenditures as well as tax breaks.
Doctors, hospitals, and insurers would continue to market their services on a
competitive basis.

This is not a French, British, or Canadian solution. It's an American,
market-based solution that Republicans should love. It's also a progressive
solution that Democrats should love. (Democratic presidential candidate Mike
Gravel has endorsed it.) The poor, who are, on average, in worse health, will
receive, on average, larger vouchers. The rich will lose their tax breaks.

Why can't a country as rich as ours come up with a system that works?...

Not the way I'd put the system together, but just wanted to point out that
this says "[Mr. Kotlikoff] is serving as an economic adviser to Mike
Gravel." It seems to me that should be made clear, especially given the implicit and explicit potshots taken at the "loser" plans of the other candidates.

David Card on "How Immigration Affects U.S. Cities". Here is the
abstract, introduction, and conclusion:

How
Immigration Affects U.S. Cities, by David Card, June 2007 [via]: Abstract
In the past 25 years immigration has re-emerged as a driving force in the size
and composition of U.S. cities. This paper describes the effects of immigration
on overall population growth and the skill composition of cities, focusing on
the connection between immigrant inflows and the relative number of less-skilled
workers in the local population. The labor market impacts of immigrant arrivals
can be offset by outflows of natives and earlier generations of immigrants.
Empirically, however, these offsetting flows are small, so most cities with
higher rates of immigration have experienced overall population growth and a
rising share of the less-skilled. These supply shifts are associated with a
modest widening of the wage gap between more- and less-skilled natives, coupled
with a positive effect on average native wages. Beyond the labor market,
immigrant arrivals also affect rents and housing prices, government revenues and
expenses, and the composition of neighborhoods and schools. The effect on rents
is the same magnitude as the effect on average wages, implying that the average
“rent burden” (the ratio of rents to incomes) is roughly constant. The local
fiscal effects of increased immigration also appear to be relatively small. The
neighborhood and school externalities posed by the presence of low-income and
minority families may be larger, and may be a key factor in understanding native
reactions to immigration.

Introduction The U.S. is once again becoming a country of immigrants.
Immigrant arrivals – currently running about 1.25 million people per year –
account for 40% of population growth nationally, and a much larger share in some
regions.[1] The effects of these inflows are controversial, in part because of
their sheer size and in part because of their composition. Something like 35-40%
of new arrivals are undocumented immigrants from Mexico and Central America with
low education and limited English skills (Passel, 2005). Although another
quarter of immigrants – from countries like India and China – are highly
skilled, critics of current immigration policy often emphasize the presumed
negative effects of lower-skilled people in the overall economy (e.g., Rector,
Kim and Watkins, 2007). Moreover, even the most highly skilled immigrants are
predominately non-white, contributing to the growing presence of visible
minorities in the U.S. population.

Paul Krugman attempts to "dispel the fog of obfuscation right-wingers use to
obscure the true nature of their position on children’s health":

A
Socialist Plot, by Paul Krugman, Commentary, NY Times: Suppose, for a
moment, that the Heritage Foundation were to put out a press release attacking
the liberal view that even children whose parents could afford to send them to
private school should be entitled to free government-run education.

They’d have a point: many American families with middle-class incomes do send
their kids to school at public expense, so taxpayers without school-age children
subsidize families that do. And the effect is to displace the private sector: if
public schools weren’t available, many families would pay for private schools
instead.

So let’s end this un-American system and make education what it should be — a
matter of individual responsibility and private enterprise. Oh, and we shouldn’t
have any government mandates that force children to get educated, either. As a
Republican presidential candidate might say, the future of America’s education
system lies in free-market solutions, not socialist models.

O.K., in case you’re wondering, I haven’t lost my mind, I’m drawing an
analogy. The real Heritage press release, titled “The Middle-Class Welfare Kid
Next Door,” is an attack on proposals to expand the State Children’s Health
Insurance Program. ... And Rudy Giuliani’s call for “free-market solutions, not socialist models”
was about health care, not education...

The truth is that there’s no difference in principle between saying that
every American child is entitled to an education and saying that every American
child is entitled to adequate health care. It’s just a matter of historical
accident that we think of access to free K-12 education as a basic right, but
consider having the government pay children’s medical bills “welfare,“ with all
the negative connotations that go with that term.

And conservative opposition to giving every child in this country access to
health care is, in a fundamental sense, un-American.

Here’s what I mean: The great majority of Americans believe that everyone is
entitled to a chance to make the most of his or her life. Even conservatives
usually claim to believe that...

But a child who doesn’t receive adequate health care, like a child who
doesn’t receive an adequate education, doesn’t have the same ... chances in life
as children who get both these things. And insurance is crucial to receiving
adequate health care...

So how can conservatives defend the indefensible, and oppose giving children
the health care they need? By trying the old welfare queen in her Cadillac
strategy (albeit without the racial innuendo that made it so effective when
Reagan used it). That is, to divert public sympathy from people who really need
help, they’re trying to change the subject to the supposedly undeserving
recipients of government aid. Hence the emphasis on the evils of “middle-class
welfare.”

Proponents of an expansion of children’s health care have, as they should,
responded to this strategy with facts and figures. Congressional Budget Office
estimates show that S-chip expansion would, in fact, primarily benefit those who
need it most: the great majority of children receiving coverage under an
expanded program would otherwise have been uninsured.

But the more fundamental response should be, so what?

We offer free education, and don’t worry about middle-class families getting
benefits they don’t need, because that’s the only way to ensure that every child
gets an education — and giving every child a fair chance is the American way.
And we should guarantee health care to every child, for the same reason.

Sunday, August 26, 2007

Larry Summers looks at three questions arising from the current financial
crises, and in response to the third says it's time for Fannie Mae and Freddie
Mac to step in and help solve the problems we are having in mortgage markets:

First there is a period of overconfidence... Second, there is a surprise that
leads investors to seek greater safety. In the current case it was the discovery
of huge problems in the subprime sector and the resulting loss of confidence in
the ratings agencies. Third, as investors rush for the exits, ... risk analysis
shifts from fundamentals to investor behaviour. As some investors liquidate
their assets, prices fall; others are in turn forced to liquidate, further
driving prices down. The anticipation of cascading liquidations leads to more
liquidations creating price movements that seemed inconceivable only a few weeks
before. The reduced availability of credit then has a negative effect on the
real economy. Eventually ... there is enough price adjustment that extraordinary
fear gives way to ordinary greed and the process of repair begins.

Only time will tell where we are in this cycle. There have been some signs of
returning normalcy over the past week, but we cannot judge whether they
represent a false spring or the end of a crisis phase. ... The impact on
consumer confidence and spending ... remains unknown.

While it is too soon to draw policy lessons, we can highlight questions the
crisis points ... out.

First, this crisis has been propelled by a loss of confidence in ratings
agencies... There is room for debate over whether the errors ... stem from a weak analysis of complex new credit instruments, or from
the conflicts induced when debt issuers pay for their ratings and can shop for
the highest rating. But there is no room for doubt that ... the ratings agencies
dropped the ball. In light of this, should bank capital standards or countless
investment guidelines be based on ratings? ... What, if any, legislative
response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial
institutions? ... The problem this time is not that banks lack capital or cannot
fund themselves. It is that the solvency of a range of non-banks is in
question... Is it wise to push banks to become public financial utilities in
times of crisis? Should there be more lending and/or regulation of the non-bank
financial institutions?

Third, what is the role for public authorities in supporting the flow of
credit to the housing sector? ... I am among the many with serious doubts about the wisdom of the government
quasi-guarantees that supported the government-sponsored entities, Fannie Mae
... and Freddie Mac ... But surely if there is ever a moment when they should
expand their activities it is now, when mortgage liquidity is drying up. No
doubt, credit standards in the subprime market were too low for too long. Now,
as borrowers face higher costs as their adjustable rate mortgages are reset, is
not the time for the authorities to get religion and discourage the provision of
credit.

This crisis could have a silver lining if it leads to the careful reflection
on these vital questions.

Does America need a recession? I say no, but The Economist has other ideas:

Does America need a recession?, The Economist: ...When the Fed cut its
discount rate on August 17th, it admitted for the first time that the credit
crunch could hurt the economy. ... Economists are arguing vigorously about how
much damage falling house prices and the subprime mortgage crisis will do. But
there is one question that is rarely asked: even if a downturn is in the offing,
should the Fed try to prevent it?

Most people think the question smacks of madness. ...

But should a central bank always try to avoid recessions? Some economists
argue that this could create a much wider form of moral hazard. If long periods
of uninterrupted expansions lead people to believe that the Fed can prevent any
future recession, consumers, firms, investors and borrowers will be encouraged
to take bigger risks, borrowing more and saving less. During the past quarter
century the American economy has been in recession for only 5% of the time,
compared with 22% of the previous 25 years. Partly this is due to welcome
structural changes that have made the economy more stable. But what if it is due
to repeated injections of adrenaline every time the economy slows? ...

The economic and social costs of recession are painful: unemployment, lower
wages and profits, and bankruptcy. These cannot be dismissed lightly. But there
are also some purported benefits. Some economists believe that recessions are a
necessary feature of economic growth. Joseph Schumpeter argued that recessions
are a process of creative destruction in which inefficient firms are weeded out.
Only by allowing the “winds of creative destruction” to blow freely could
capital be released from dying firms to new industries. ...

Another “benefit” of a recession is that it purges the excesses of the
previous boom, leaving the economy in a healthier state. The Fed's massive
easing after the dotcom bubble burst delayed this cleansing process and simply
replaced one bubble with another, leaving America's imbalances (inadequate
saving, excessive debt and a huge current-account deficit) in place. A recession
now would reduce America's trade gap as consumers would at last be forced to
trim their spending. Delaying the correction of past excesses ... is likely to
make the eventual correction more painful. The policy dilemma facing the Fed may
not be a choice of recession or no recession. It may be a choice between a mild
recession now and a nastier one later.

This does not mean that the Fed should follow the advice of Andrew Mellon,
the treasury secretary, after the 1929 crash: “liquidate labour, liquidate
stocks, liquidate the farmers, and liquidate real estate...It will purge the
rottenness out of the system.” America's output fell by 30% as the Fed sat on
its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's
chairman, will not make that mistake. Central banks must stop recessions from
turning into deep depressions. But it may be wrong to prevent them altogether.

Of course, even if a recession were in America's long-term economic interest,
it would be political suicide. A central banker who mentioned the idea might
soon be out of a job. But that should not stop undiplomatic economists asking
whether a recession once in a while might actually be a good thing.

So let's talk undiplomatically about this:

1. I disagree that we need recessions to have a dynamic economy. Equilibrium
means (in simple terms) "no tendency for change" and there is nothing
inconsistent with having a constant flow of entering and exiting firms at
equilibrium.

When profits are high - as in the traditional price signaling story - there
is a rush to enter industries, but the trick is to get there first and take some
of the profits before others beat you to it, innovation and technological change
are not so important. There are lots of profits to be had by entering with
existing technology so, while it does allow the installation of the best and
latest technology, there's no strong pressure to innovate. In fact waiting until
there is an innovation could be costly.

It's when conditions are tight, i.e. when everyone is making close to zero
economic profit, that new cost saving or demand enhancing technological change
will pay off. If you have a better product or lower costs than rivals, then you
will gain an edge and realize profits. The only way to get ahead is to build a
better mousetrap. Sure, conditions will be tight in recessions - that's the
traditional creative destruction story - but things are tight in a competitive
equilibrium too and the pressure to innovate does not disappear just because the
economy is operating at full employment.

So I don't see why a full-employment equilibrium cannot also be a dynamic
economy. That is, suppose there is an industry with 1,000 firms in it all doing
about the same thing (producing pizza), but every year (at a continuous rate
throughout the year), 100 go out of business and are replaced by 100 new firms
with a cost advantage or better product (let's put cheese in the crust!). There
is no recession here, a firm comes up with a better idea, enters (leading to
temporary overemployment), and drives someone else out of business.

I am not an Austrian economist and I don't play one on the internet, so I
won't claim to be able to recite what Schumpeter (or anyone else in the Austrian
camp) said about this on a particular page of one of his books, so maybe someone
who is an adherent to this "we need business cycles" approach can explain why we
cannot wipe out the inefficient while remaining at or very near full-employment.

2. Overproducing houses is not like overproducing goods that cannot be
stored, i.e. perishables. When too much popcorn is produced relative to demand,
it goes to waste. Resources that could be used elsewhere are wasted forever
since the excess can't be frozen or stored for the future (or at least assume so
for the purposes of illustration, there is that stuff in movie theaters). With
houses, there is an intertemporal shift in resource use, but since houses don't
spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in
underproduction tomorrow. The houses were built too soon, and that's an
efficiency loss because we gave something up, but when we produce less houses
later we can recover (some of) the goods that were lost (too many houses and too few cars
in year one, but in year two it's the opposite, too few houses and too many cars
relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage
means we didn't have the opportunity to produce less later, so there is no way
to make up for it, even in part, later on.

That is to say, I hope we don't "creatively destroy" the houses that were (over)built.
Sure, some can be creatively transformed into restaurants, business offices,
etc., to attenuate the misallocation in the short-run, but there's no need to
tear them down and replace them. With time, population and demand will grow, and
the houses will be filled. Hula hoop factories needed to be creatively
destroyed, they needed to be torn down and replaced - it's unlikely demand will
return in the future so having those factories around would be a waste, they
would never be re-opened - but houses are not hula hoops. With houses, there is
no need to "purge the excesses of the previous boom," just wait for population
to catch up (and would it be so bad to have low cost housing available in the interim?).

3. I don't understand the reasoning that says the Fed should not stabilize
the economy because it will "create a much wider form of moral hazard. If long
periods of uninterrupted expansions lead people to believe that the Fed can
prevent any future recession."

The reasoning is that if we stabilize the economy, people will then believe
recessions are impossible (or underestimate their likelihood) and make bad
decisions, so we shouldn't stabilize at all.

People who believe the Fed can prevent all economic fluctuations will be, so
to speak, "creatively destructed" the first time there is a recession. But to
refuse to stabilize the economy to the best of our ability because we are afraid
people might misperceive the degree of stability that is attained seems
misguided to me. I would have thought an Austrian response would be to do what's
best for the economy and let those who misperceive be weeded out by the market
process (or better yet, that they become informed about the true risks - this is
a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the
information, not to refuse to stabilize).

It's very telling (and a bit scary) when these
guys reveal their true objectives. Assuming this isn't satire, and it doesn't appear that it is (it's so far
from sane that it's hard to tell), here's a call to, among other things, wipe out the population of Iraq with nuclear weapons, replace them with Americans, and install Bush as our permanent president. From Crooked Timber:

A website run by the neocon thinktank the
Center for Security Policy
(members include Frank Gaffney, Richard Perle and Doug Feith) has published
(then removed) a piece calling for Bush to use his military powers to become
“the first permanent president of America” and “ruler of the world”. Along the
way he suggests that the population of Iraq should have been wiped out. The
website Family Security Matters
also runs pieces by Newt Gingrich, Judy Miller and other luminaries.

As someone would say (though maybe not in this case) “read the whole thing”.
It’s impossible to tell if this is satire by someone who has cleverly
infiltrated FSM over a lengthy period (quite a few
other pieces by the same author, Philip Atkinson were also removed), a sudden
outbreak of insanity (unlikely since Atkinson previously published stuff almost
as extreme as this,
with the endorsement of FSM), or the actual views
of CSP/CFM, accidentally revealed and clumsily
concealed.

As things stand, there’s a presumption in favor of the last of these views.
The piece was published by CSP/FSM and constitutes, at
present, their last word on the subject. If they repudiate Atkinson’s views they
should say so openly, and live with the embarrassment of having published him
and praised his ideas until now.

Here's Atkinson's editorial from the link above:

Conquering the Drawbacks of Democracy, by Philip Atkinson: President
George W. Bush is the 43rd President of the United States. He was sworn in for a
second term on January 20, 2005 after being chosen by the majority of citizens
in America to be president.

Yet in 2007 he is generally despised, with many citizens of Western
civilization expressing contempt for his person and his policies, sentiments
which now abound on the Internet. This rage at President Bush is an inevitable
result of the system of government demanded by the people, which is Democracy.

The inadequacy of Democracy, rule by the majority, is undeniable -- for it
demands adopting ideas because they are popular, rather than because they are
wise. This means that any man chosen to act as an agent of the people is placed
in an invidious position: if he commits folly because it is popular, then he
will be held responsible for the inevitable result. If he refuses to commit
folly, then he will be detested by most citizens because he is frustrating their
demands.

When faced with the possible threat that the Iraqis might be amassing
terrible weapons that could be used to slay millions of citizens of Western
Civilization, President Bush took the only action prudence demanded and the
electorate allowed: he conquered Iraq with an army.

This dangerous and expensive act did destroy the Iraqi regime, but left an
American army without any clear purpose in a hostile country and subject to
attack. If the Army merely returns to its home, then the threat it ended would
simply return.

The wisest course would have been for President Bush to use his nuclear
weapons to slaughter Iraqis until they complied with his demands, or until they
were all dead. Then there would be little risk or expense and no American army
would be left exposed. But if he did this, his cowardly electorate would have
instantly ended his term of office, if not his freedom or his life.

The simple truth that modern weapons now mean a nation must practice genocide
or commit suicide. Israel provides the perfect example. If the Israelis do not
raze Iran, the Iranians will fulfill their boast and wipe Israel off the face of
the earth. Yet Israel is not popular, and so is denied permission to defend
itself. In the same vein, President Bush cannot do what is necessary for the
survival of Americans. He cannot use the nation's powerful weapons. All he can
do is try and discover a result that will be popular with Americans.

As there appears to be no sensible result of the invasion of Iraq that will
be popular with his countrymen other than retreat, President Bush is reviled; he
has become another victim of Democracy.

By elevating popular fancy over truth, Democracy is clearly an enemy of not
just truth, but duty and justice, which makes it the worst form of government.
President Bush must overcome not just the situation in Iraq, but democratic
government.

However, President Bush has a valuable historical example that he could
choose to follow.

When the ancient Roman general Julius Caesar was struggling to conquer
ancient Gaul, he not only had to defeat the Gauls, but he also had to defeat his
political enemies in Rome who would destroy him the moment his tenure as consul
(president) ended.

Caesar pacified Gaul by mass slaughter; he then used his successful army to
crush all political opposition at home and establish himself as permanent ruler
of ancient Rome. This brilliant action not only ended the personal threat to
Caesar, but ended the civil chaos that was threatening anarchy in ancient Rome –
thus marking the start of the ancient Roman Empire that gave peace and
prosperity to the known world.

If President Bush copied Julius Caesar by ordering his army to empty Iraq of
Arabs and repopulate the country with Americans, he would achieve immediate
results: popularity with his military; enrichment of America by converting an
Arabian Iraq into an American Iraq (therefore turning it from a liability to an
asset); and boost American prestiege while terrifying American enemies.

He could then follow Caesar's example and use his newfound popularity with
the military to wield military power to become the first permanent president of
America, and end the civil chaos caused by the continually squabbling Congress
and the out-of-control Supreme Court.

President Bush can fail in his duty to himself, his country, and his God, by
becoming “ex-president” Bush or he can become "President-for-Life" Bush: the
conqueror of Iraq, who brings sense to the Congress and sanity to the Supreme
Court. Then who would be able to stop Bush from emulating Augustus Caesar and
becoming ruler of the world? For only an America united under one ruler has the
power to save humanity from the threat of a new Dark Age wrought by terrorists
armed with nuclear weapons.

FamilySecurityMatters.org Contributing Editor Philip Atkinson is the British
born founder of ourcivilisation.com and author of A Study of Our Decline. He is
a philosopher specializing in issues concerning the preservation of Western
civilization. Mr. Atkinson receives mail at
rpa@ourcivilisation.com.

Note -- The opinions expressed in this column are those of the author and do
not necessarily reflect the opinions, views, and/or philosophy of The Family
Security Foundation, Inc.

Just to be sure, I checked the
website Family Security Matters for a statement on this, but nothing. As noted above, there's an article by Newt Ginrich and also articles by many others (e.g. Judith Miller), so apparently they have no problem whatsoever publishing in the same venue as Atkinson, but there's nothing explicitly disavowing Atkinson's views.

I have worked with Karl E. Case ... at Wellesley College ... in conducting
... surveys of recent home buyers. In Los Angeles and San Francisco in 2005,
when actual home prices were rising more than 20 percent a year, we found that
respondents anticipated big increases far into the future..., the median
expected annual climb for the succeeding 10 years was 9 percent.

This expectation would mean that a house valued at an already high level of
$650,000 in 2005 would be worth more than $1.5 million in 2015. For most people
in 2005, it would also mean that they should buy a house soon, or forever be
excluded from owning one — and that it would be better to stretch and buy the
most expensive house they could afford...

Now, of course, prices have been falling, and our survey over the last few
months shows that in Los Angeles and San Francisco, the median 10-year expected
price increase among recent home buyers has come down to 5 percent a year — a
number that is likely to decline further if prices continue to drop. As price
expectations fall, homeowners lose the incentive to pay off a mortgage on a home
they are realizing is beyond their means. They decide to default. We thus have
the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high
home prices and declining optimism that the prices will go higher. Cutting
interest rates will not change this basic situation. The problem is fundamental
because the speculative cycle afflicts much of the world. ...

Classical economics cannot explain this cycle, because underlying these booms
is popular reaction to the price increases themselves. Rising prices encourage
investors to expect more price increases, and their optimism feeds back into
even more increases, again and again in a vicious circle. As the boom continues,
there is less fear of borrowing heavily, or of lending heavily. In this
situation, lower lending standards seem perfectly appropriate — and even a fair
way to permit everyone to prosper.

Booms cannot go on forever. Downward price feedback sets in. That is when
balance sheets become impaired and widening credit problems start to show up.

The puzzle is why this speculative cycle has occurred recently in so much of
the world. What do all these countries share that drives them to speculative
booms? ...

As we all try to adjust to a rapidly growing and increasingly capitalist
world, we have been trying to discover who we are and how we fit into it. This
has meant an enormous change in values.

Many people feel that they have discovered their true inner genius as
investors and have relished the new self-expression and excitement. Investors
across the world have been thinking that they are winners — not recognizing that
much of their success is only a result of a boom. Declines in asset prices
endanger this very self-esteem.

That is why it is so hard to turn around investor attitudes once a downward
psychology sets in. The Fed and other central banks do not have lithium or
Prozac in their bag of remedies, and so cannot control it.

I don't have much to say in response to this, maybe you can come up with something, but let me point you to a much more detailed discussion of this topic by Shiller:

Historic Turning Points in Real Estate, by Robert Shiller, Cowles Foundation Discussion Paper No. 1610, June 2007: Abstract This paper looks for markers of ends of real estate booms or busts. The changes in market psychology and related indicators that occurred at real estate market turning points in the United States since the 1980s are compared with changes at turning points in the more distant past. In all these episodes changes in an atmosphere of optimism about the future course of home prices, changes in public interpretation of the boom, as well as evidence of supply response to the high prices of a boom, are noted.

Introduction By some accounts, the greatest challenge for economic forecasters is to
predict turning points. It is easy to extrapolate time series. It is less easy
to tell when the series will abruptly change trend and enter a different pattern
or regime.

Figure 1 shows a chart of US stock price and home price indices since 1987.
It shows the Standard & Poor 500 Stock Price Index... It also shows the Standard & Poor/Case-Shiller
Composite Home Price Index, a ten-city average which is a measure of the
aggregate market for single family homes, and is based on indices that Karl Case
and I created in 1988. ... Since the home price index is a threemonth moving
average, the S&P 500 is also plotted as a moving three-month moving average so
that the two series are comparable.

Notes on
the Federal Reserve's Current Actions, by Brad DeLong: The Federal
Reserve is now focusing on what Larry Meyer calls "liquidity tools" to make sure
the market for short-term credit functions despite concerns about counterparty
risk and collateral values. The Federal Reserve hopes that it can handle the
current situation without having to ease monetary policy--that its liquidity
tools will do enough, and that it won't feel forced to rescue market liquidity
by cutting interest rates and thus giving what it fears would be an unhealthy
boost to spending. (I think the Federal Reserve is wrong here: the fallout from
the current liquidity panic means that a year from now we are likely to wish
that the Federal Reserve had given a boost to spending today.)

The New York Federal Reserve Bank has not pegged the average funds rate to
its 5.25% target, and it now says that it wants to see "trading in the federal
funds market at rates close" to 5.25%, not at 5.25%, and the rate has not been
at the target for a week. Nevertheless, the target rate has not changed.

My view is that the FOMC is likely to cut the federal funds rate by 25 basis
points at its September meeting, but it will do so reluctantly, because markets
expect it, not because it believes the situation warrants it.

Of course, if the financial panic-in-embryo starts to affect spending and to
slow the real economy, the FOMC will start cutting rates much further and
faster.

Brad mentions something I've been wondering and meaning to bring up here. Would/could the Fed set the
target rate at a level different from what markets expect? Certainly if there is
a split in expectations, say 50% expect the Fed to hold at 5.25% and 50% expect
the Fed to cut the target rate to 5.00%, they would have to go one way or the
other, but suppose it is 95% for a rate cut, 5% to hold. Does the Fed currently
have the courage and credibility to deviate from what it is expected to do by the vast majority of market participants? Brad
says no - it will do what the markets expect, even if it thinks the move is not warranted.

That's my sense too and, if that is correct, policy right now is mainly about
managing expectations since that determines the rate that will prevail. Maybe
I'm wrong - perhaps he Fed would do what it thinks is best whether or not
markets expect it - but I think they are largely bound by prevailing market
opinion.

Ben Bernanke is still being tested, still establishing his credibility.
If he deviates from expectations and turns out to be wrong, then his choice will
be questioned - why didn't he listen to the markets? - and the credibility loss
could be large (just an academic book guy, not like dear old Alan...). Of
course, if he deviates from expectations and is correct he would be hailed, but
it is a risky strategy to deviate from expectations at this point.

If the Fed is
successful at managing expectations, we'll never know about this since they
would always do as expected, and I've assumed the Fed is fairly united itself in
what ought to happen (they could be split as well and deliver mixed signals),
but I think there is a good chance they will face this choice soon and, if they
cannot shift market expectations prior to the meeting, will give in to market
opinion. I'm not 100% positive about that, but I do think maintaining credibility
going forward - as much as possible - is a substantial constraint on their
choices.

For those who never heard about it, the FairTax is a national retail sales
tax that would replace the entire current federal tax system. ...

Rep. John Linder (R., Ga.) and Sen. Saxby Chambliss (R., Ga.) have introduced
legislation ... to implement the FairTax. They assert that a rate of 23% would
be sufficient to replace federal individual and corporate income taxes as well
as payroll and estate taxes. Mr. Linder's Web site claims that U.S. gross
domestic product will rise 10.5% the first year after enactment, exports will
grow by 26%, and real investment spending will increase an astonishing 76%.

In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get
this figure by calculating the tax as if it were already incorporated into the
price of goods and services. ...[T]hink of it this way. If a product costs $1 at
retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23%
of $1.30, FairTax supporters say the rate is 23% rather than 30%.

This is only the beginning of the deceptions in the FairTax. Under the
Linder-Chambliss bill, the federal government would have to pay taxes to itself
on all of its purchases of goods and services. Thus if the Defense Department
buys a tank that now costs $1 million, the manufacturer would have to add the
FairTax.... The tank would then cost the federal government $300,000 more than
it does today, but its tax collection will also be $300,000 higher.

This legerdemain is done solely to make revenues under the FairTax seem
larger than they really are, so that its supporters can claim that it is
revenue-neutral. ...

Similarly, state and local governments would have to pay the FairTax on most
of their purchases. This means that it is partly financed by higher state and
local taxes. ...

State sales taxes have long exempted all but a few services because of the
enormous difficulty in taxing intangibles. But the FairTax would apply to 100%
of services, including medical care, thus increasing their cost by 30%. No state
comes close to taxing services so broadly. Consumers would also find themselves
taxed on newly constructed homes. Imagine paying 30% ... on top of the purchase
price...

Since sales taxes are regressive ... some provision is needed to prevent a
vast increase in taxation on the nonwealthy. The FairTax does this by sending
monthly checks to every household based on income. Aside from the incredible
complexity and intrusiveness of tracking every American's monthly income ... the
FairTax does not include the cost of this rebate in the tax rate. ...

Rejecting all the tricks of FairTax supporters and calculating the tax rate
honestly ... professional revenue estimators have always concluded that a
national retail sales tax would have to be much, much higher than 23%.

A 2000 estimate by Congress's Joint Committee on Taxation found the ... rate
would be 57%. In 2005, the U.S. Treasury Department calculated that a ... rate
of 34% would be needed just to replace the income tax, leaving the payroll tax
in place. ...

Perhaps the biggest deception in the FairTax, however, is its promise to
relieve individuals from having to file income tax returns, keep extensive
financial records and potentially suffer audits. Judging by the emphasis FairTax
supporters place on the idea of making April 15 just another day, this seems to
be a major selling point for their proposal.

Yet all but six states now have state income taxes. So unless one lives in
one of those states, this promise is an empty one indeed. In short, the FairTax
is too good to be true, and voters should not take seriously any candidate who
supports it.

CALLER: Hey, Rush. ... I talked to you once before. ... I know I'm no expert
in foreign affairs, but what really confuses me about the liberals is the
hypocrisy when they talk about how we have no reason to be in Iraq and helping
those people, but yet everybody wants us to go to Darfur. I mean, aren't we
going to end up in a quagmire there? I mean, isn't it -- I don't understand. Can
you enlighten me on this?

LIMBAUGH: Yeah. This is -- you're not going to believe this, but it's very
simple. And the sooner you believe it, and the sooner you let this truth
permeate the boundaries you have that tell you this is just simply not possible,
the better you will understand Democrats in everything. You are right. They want
to get us out of Iraq, but they can't wait to get us into Darfur.

CALLER: Right.

LIMBAUGH: There are two reasons. What color is the skin of the people in
Darfur?

CALLER: Uh, yeah.

LIMBAUGH: It's black. And who do the Democrats really need to keep voting for
them? If they lose a significant percentage of this voting bloc, they're in
trouble.

CALLER: Yes. Yes. The black population.

LIMBAUGH: Right. So you go into Darfur and you go into South Africa, you get
rid of the white government there. You put sanctions on them. You stand behind
Nelson Mandela -- who was bankrolled by communists for a time, had the support
of certain communist leaders. You go to Ethiopia. You do the same thing.

CALLER: It's just -- I can't believe it's really that simple.

[...]

LIMBAUGH: Right. That's exactly right. You've got it. You've got it. Now you
just have to believe your own instincts from here on out.

I'm sure I don't have to point out that there are no elected Democrats who
"can't wait to get us into Darfur" unless you consider Joe Biden's passionate
outbursts about Darfur in the debates to be proof of such a thing. In fact,
Darfur is a human tragedy of epic proportions ... and pretty much nobody,
certainly not the political class of either party, is much interested in it. So
let's just set that aside.

The hideous, racist assumptions in that little "analysis" are so blatant that
it's startling, even from the disgusting Limbaugh. The charge that African
American voters vote on the basis of African politics is so bizarre I don't even
know how to deal with it. And anyway, even if it were true, the fact that the
Republicans ... insisted on supporting apartheid until the bitter end would
likely have been the motive, especially since those same Republican[s] ...
couldn't stop talking about welfare queens and running their political campaigns
based on thinly veiled racist attacks. While I'm sure black Americans care about
Darfur and South Africa as much as the next decent human being, they know very
well that the Republican party is filled with ... haters like Limbaugh who
despise them. Voting for the Democrats isn't really that complicated in light of
that.

And apparently, the only reason he and his ... listeners can imagine that
anyone would oppose apartheid in South Africa or be horrified at the genocide in
Darfur is their own craven political interests. I'm afraid that says more about
him than it does about Democrats. ...

Look for more of this over the next few months as the Republicans make their
case against "the Bitch," "the Black" and "the Breck girl." Limbaugh and Coulter
and the boys will do this kind of crude dirty work for them, but there is going
to be an awful lot of it that's way more subtle.

Yes, it's really going to be this bad.

"you get
rid of the white government there. You put sanctions on them. You stand behind
Nelson Mandela -- who was bankrolled by communists"

The Pentagon thought U.S. firms would be willing to help revitalize the
war-torn Iraqi economy and create jobs for young men who might otherwise join
the insurgency. But the effort -- once considered a pillar of the U.S. strategy
in Iraq, alongside security operations and political reform -- has suffered from
a pervasive lack of security and an absence of reliable electricity and other
basic services.

Iraqi officials have recently highlighted pending deals with retailers such
as Wal-Mart and J.C. Penney, businesses that they said were considering
purchasing Iraqi products from the few local factories that have restarted. But
the two companies said last week that they are not in negotiations to buy Iraqi
products...

Three officials who have worked with the Pentagon's Task Force to Support
Business and Stability Operations in Iraq said in recent interviews that,
although some factories have achieved limited success, the larger effort to link
Iraqi industries with U.S. retailers has been a "failure." ...

The task force's assumption from the outset -- one shared by top U.S.
commanders in Iraq and senior leaders at the Pentagon -- was that jump-starting
Iraqi factories would push young men into paying jobs and away from violence.

But, in the past year, only 4,000 jobs have been created... Those results come against the backdrop of a grim overall economic picture...

Suppose Bush had engaged in a no holds barred attempt to get firms to
cooperate in this venture, used his bully pulpit at every opportunity to tell firms it's their patriotic duty and used all the
usual slime machine tricks against those who don't cooperate. If he had gone all out
and asked his business buddies to sacrifice for the cause (for once), told them that if
young men can give their lives, can't you help as well, could that have made a
difference? Or was it always hopeless? I've always thought we tried this much
too late, so we'll never know for sure.

Why did we wait? The idea initially was that the free market would
work its magic and somehow provide the jobs that were needed, so there
was no need to protect former state-run enterprises -- those needed to
be replaced in the name of efficiency. I wonder if adherence to that
ideology rather than adopting a top-down planned approach that kept
formerly state-run enterprises open and running (and opened more if
needed) from the start would have changed the subsequent course of
events. Forget efficiency, there was plenty of time ahead to worry
about that, just put people to work doing something, anything. There
was plenty that needed to be done.

[Update: Dani Rodrik follows up, "Thoma is right of course. And it gives me pleasure to welcome him to the
industrial policy sympathizers club..."]

[T]he radical restructuring of Iraq's political economy has received ...
little critical attention.... It was taken as a given that after knocking off
Saddam, we'd rapidly privatize huge swaths of Iraq's national companies, get rid
of hundreds of thousands of civil servants, completely restructure the country's
tax and finance laws and throw Iraq's economy wide open for foreign
multinationals. ...

Paul Krugman looks at GOP efforts to revive Willie Horton and what that means for the future of the party:

Seeking Willie Horton, by Paul Krugman, Commentary, NY Times: So now Mitt
Romney is trying to Willie Hortonize Rudy Giuliani. And thereby hangs a tale —
the tale, in fact, of American politics past and future, and the ultimate reason
Karl Rove’s vision of a permanent Republican majority was a foolish fantasy.

Willie Horton, for those who don’t remember the 1988 election, ... committed
armed robbery and rape after being released from prison on a weekend furlough
program. He was made famous by an attack ad ... that played into racial fears.
Many believe that the ad played an important role in George H.W. Bush’s victory
over Michael Dukakis.

Now some Republicans are trying to make similar use of the recent murder of
three college students in Newark, a crime in which two of the suspects are
Hispanic illegal immigrants. ...

Mr. Romney, who pretends to be whatever he thinks the G.O.P. base wants him
to be, is running a radio ad denouncing New York as a “sanctuary city” for
illegal immigrants, an implicit attack on Mr. Giuliani.

Strangely, nobody seems to be trying to make a national political issue out
of other horrifying crimes, like the Connecticut home invasion in which two
paroled convicts, both white, are accused of killing a mother and her two
daughters. ...

To appreciate what’s going on here you need to understand the ... strategy
[the G.O.P.] uses to win elections. ... [R]ight-wing economic ideology has never
been a vote-winner. Instead, the party’s electoral strategy has depended largely
on exploiting racial fear and animosity.

Ronald Reagan didn’t become governor of California by preaching the wonders
of free enterprise; he did it by attacking the state’s fair housing law,
denouncing welfare cheats and associating liberals with urban riots. Reagan
..[began] his 1980 campaign with a speech ... supporting states’ rights
delivered just outside Philadelphia, Miss., where three civil rights workers
were murdered in 1964.

And if you look at the political successes of the G.O.P. since it was taken
over by movement conservatives, they had very little to do with public
opposition to taxes, moral values, perceived strength on national security, or
any of the other explanations usually offered. To an almost embarrassing extent,
they all come down to just five words: southern whites starting voting
Republican. ...

But Republicans have a problem: ... America is becoming less white, mainly
because of immigration. Hispanic and Asian voters were only 4 percent of the
electorate in 1980, but they were 11 percent of voters in 2004 — and that number
will keep rising...

Those numbers are the reason Karl Rove was so eager to reach out to Hispanic
voters. But the whites the G.O.P. has counted on to vote their color, not their
economic interests, are having none of it. From their point of view, it’s us
versus them — and everyone who looks different is one of them.

So now we have the spectacle of Republicans competing over who can be most
convincingly anti-Hispanic. I know, officially they’re not hostile to Hispanics
in general, only to illegal immigrants, but that’s a distinction neither the
G.O.P. base nor Hispanic voters takes seriously.

Today’s G.O.P., in short, is trapped by its history of cynicism. For decades
it has exploited racial animosity to win over white voters — and now, when
Republican politicians need to reach out to an increasingly diverse country, the
base won’t let them.

William Gross explains why we need to rescue housing, and that fiscal, not
monetary policy is the solution for struggling homeowners:

Why We Need a Housing Rescue, by William H. Gross, Commentary, Washington Post: During times of market turmoil, it helps to get down to basics. ... Financial
institutions lend trillions ... among each other. The Fed lends to banks, which
lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to
hedge funds, and so on. The food chain is not one of predator feasting on prey
but a symbiotic credit extension, always for profit but never without trust that
the money will be repaid... When the trust breaks down, money is figuratively
stuffed into Wall Street and London mattresses as opposed to extended to the
increasingly desperate hedge funds and other financial conduits. These
structures in turn are experiencing runs from depositors and lenders exposed to
asset price declines of unexpected proportions. In such an environment, markets
become incredibly volatile...

The past few weeks have exposed a giant crack in modern financial
architecture... While the newborn derivatives may hedge individual,
institutional and sector risk, they cannot hedge liquidity risk. ... Only the
central banks can solve this, with their own liquidity infusions and perhaps a
series of rate cuts.

Should markets be stabilized, policymakers must then decide what to do about
the housing market. Seventy percent of American households are homeowners.
Granted, a dose of market discipline in the form of lower prices might be
healthy, but forecasters are projecting more than 2 million defaults... The
resulting impact on housing prices is likely to be close to a 10 percent
decline. Such an asset deflation has not been seen in the United States since
the Great Depression.

Housing prices could probably be supported by substantial cuts in short-term
interest rates, but even cuts of 2 to 3 percentage points by the Fed would not
avert an increase in interest rates of adjustable-rate mortgages; nor would they
guarantee that the private mortgage market -- flush with fears of depreciating
collateral -- would follow along in terms of 30-year mortgage yields and relaxed
lending standards. Additionally, cuts of such magnitude would almost guarantee a
resurgence of speculative investment via hedge funds and levered conduits. Such
a move would also more than likely weaken the dollar -- even produce a run...

The ultimate solution must not emanate from the Fed but from the White House.
Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s
the government absorbed the bad debts of the failing savings and loan industry.
Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners
must be thrown to the wolves today? If we can bail out Chrysler, why can't we
support American homeowners?

Critics warn of a "moral hazard." If we bail out homeowners this time, they
claim, it will just encourage another round of speculation in the future. But
there's never been a problem in terms of national housing price bubbles until
recently. Home prices have been the most consistent, least bubbly asset aside
from Treasury bills for the past 50 years. Only in the past few years, when
regulation has broken down, when the Fed has failed to exercise appropriate
supervision, have we seen "no-doc" and "liar" loans and "100 percent plus"
loans. If you enforce regulation, you'll have no problem with moral hazard.

This rescue, which admittedly might bail out speculators who deserve much
worse, would support millions of hardworking Americans. ...

Get with it, Mr. President. This is your moment to one-up Barney Frank and
the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least,
modify the existing FHA program, long discarded as ineffective. Bail 'em out --
and prevent a destructive housing deflation that Ben Bernanke cannot avert.
After all, you're the Decider, aren't you?

Another paper from Michael Woodford. In this one, he asks if globalization
means that the Fed will lose the ability to influence inflation:

Globalization and Monetary
Control, by Michael Woodford, NBER WP 13329, August 2007: Abstract It
has recently become popular to argue that globalization has had or will soon
have dramatic consequences for the nature of the monetary transmission
mechanism, and it is sometimes suggested that this could threaten the ability of
national central banks to control inflation within their borders, at least in
the absence of coordination of policy with other central banks. In this paper, I
consider three possible mechanisms through which it might be feared that
globalization can undermine the ability of monetary policy to control
inflation... These three fears relate to potential changes in the form of the
three structural equations of a basic model of the monetary transmission
mechanism: the LM equation, the IS equation, and the AS equation respectively.

What are the three factors that potentially change the IS, LM, and AS curves?

On the one hand, it might be thought that in a globalized world, it is
"global liquidity" that should determine world interest rates rather than the
supply of liquidity by a single central bank (especially a small one); thus one
might fear that a small central bank will no longer have any instrument with
which to shift the LM curve. Alternatively, it might be thought that changes in
the balance between investment and saving in one country should matter little
for the common world level of real interest rates, so that the "IS curve" should
become perfectly horizontal even if the LM curve could be shifted. It might then
be feared that loss of control over domestic real interest rates would eliminate
any leverage of domestic monetary policy over domestic spending or inflation. Or
as still another possibility, it might be thought that inflation should cease to
depend on economic slack in one country alone (especially a small one), but
rather upon "global slack"; in this case the AS curve would become horizontal,
implying that even if domestic monetary policy can be effectively used to
control domestic aggregate demand, this might not allow any control over
domestic inflation.

And he finds that:

I take up each of these possibilities, by discussing the effects
of openness (of goods markets, of factor markets, and of financial markets) on
each of these three parts of a "new Keynesian" model of the monetary
transmission mechanism. I first consider each argument in the context of a
canonical open-economy monetary model..., and show that openness need not have
any of the kinds of effects that I have just proposed. In each case, I also
consider possible variants of the standard model in which the effects of
globalization might be more extreme. These cases are not always intended to be
regarded as especially realistic, but are taken up in an effort to determine if
there are conditions under which the fear of globalization would be justified.
Yet I find it difficult to construct scenarios under which globalization would
interfere in any substantial way with the ability of domestic monetary policy to
maintain control over the dynamics of domestic inflation.

It is true that, in a globalized economy, foreign developments
will be among the sources of economic disturbances to which it will be
appropriate for a central bank to respond, in order for it to achieve its
stabilization goals. But there is little reason to fear that the capacity of
national central banks to stabilize domestic inflation, without having to rely
upon coordinated action with other central banks, will be weakened by increasing
openness of national economies.

The agencies reply that accurately accounting for risk is not their job and
that they are protected by the right of free speech. They point to disclaimers
... that make it clear that they are paid by the companies they rate and that
ratings are statements of opinion, not recommendations. ...

[S]uch admonitions ring hollow. Ratings agencies do more than opine; they
play an active role in structuring RMBS and CDOs. They also serve as important
sources of information about securitisation performance and often enumerate
measures that issuers must take to maintain ratings in troubled securitisations.

More importantly, unlike typical market actors, ratings agencies are more
likely to be insulated from the standard market penalty for being wrong, namely
the loss of business. Issuers must have ratings, even if investors do not find
them very accurate. ... Portfolio regulations for banks, insurance companies and
pension funds set minimum ratings on debts these intermediaries are permitted to
purchase. Thus, government has transferred substantial regulatory power to
ratings agencies, since they now effectively decide which securities are safe
enough for regulated intermediaries to hold.

Giving ratings agencies more power actually reduces the value of their
ratings by creating a strong incentive for grade inflation and making the
meaning of ratings harder to discern. Regulated investors encourage ratings
agencies to understate risk so that the menu of high-yielding securities
available to them is larger. The regulatory use of ratings thus has changed the
constituency demanding a rating from free-market investors interested in a
conservative opinion to regulated investors looking for an inflated one.

Grade inflation has been concentrated particularly in securitised products,
where the demand is especially driven by regulated intermediaries. In 1994,
economists Richard Cantor and Frank Packer ... pointed out that grade inflation
was ... driven by the least reputable ratings agencies: “...Most ‘third’
agencies ... assign significantly higher ratings on average than Moody’s and
Standard & Poor’s.” ...

Although there is evidence that Moody’s and S&P remain relatively
conservative..., it is clear that even Moody’s has allowed its ratings scale for
securitised products to become inflated. Bloomberg Markets reported in July
that: “Corporate bonds rated Baa, the lowest Moody’s investment grade rating,
had an average 2.2 per cent default rate over five-year periods from 1983 to
2005... From 1993 to 2005, CDOs with the same Baa grade suffered five-year
default rates of 24 per cent, Moody’s found.” In other words, long before the
current crisis, Moody’s was aware that its Baa CDO securities were 10 times as
risky as its Baa corporate bonds.

Given the different and shifting meanings of Baa and other ratings as
measures of risk and given the high rate of financial innovation and the lack of
transparency inherent in multi-layered structured finance deals, it is not
surprising that investors underestimated risks so badly leading up to the recent
crisis.

It is no use blaming the ratings agencies, which are simply responding to the
incentives inherent in the regulatory use of ratings. The solution is for
regulators to reclaim the power that has been transferred to ratings agencies...

How can regulatory power be reclaimed? ...[One] solution is to reform
existing regulations to avoid the use of letter grades in setting standards for
permissible investments by regulated institutions. In the absence of letter
grades, banks and their regulators would look at the underlying risks of
investments, not ratings. Indeed, ratings agencies sell tools to investors that
permit exactly this sort of analysis. Full disclosure by regulated institutions
of these new measures of portfolio risks and a greater reliance on market
discipline to discourage excessive risk-taking would further improve the
regulatory process.

Another solution I saw elsewhere is to
assign the companies to the rating agencies randomly so that today's rating
does not affect the probability of getting business from that firm in the
future. But I'm not sure how to impose market discipline on the firms that issue
poor ratings if the assignments are random. If I know I will get a certain
percentage of business (by random draw) no matter what, then there is no penalty
for being wrong. I like the idea of randomization because it breaks the link
between inflated ratings and getting more business, but the percentage of
business a firm is assigned should be connected to their success at rating
companies, and there would need to be a mechanism for entry and exit. Thus, over
time firms who do best would increase their share, and firms who do worse would
lose out and eventually be dropped opening up a spot (by bid?) for a new firm to
enter.

I'm interested in hearing other proposals to create incentives for ratings
agencies to issue accurate assessments.

Update: In comments, two stories have emerged:

Were the signals bad? Even the article says that the tools are
available to do more detailed analysis, so why didn't they if so much was at stake? Still, one has the sense
risks weren't fully understood for some reason and bad signals are one
possibility.

Or were the signals fine, but ignored due to some market failure or
incentive incompatibility where, for example, those making decisions do not have a
full stake in the losses and hence do not fully account for risk? I
think this has merit, or at least warrants thinking harder about.

According to this paper that is forthcoming in the Journal of Political
Economy, "a one percentage point increase in the ratio of immigrants to natives
in a city decreases prices by 0.5 percentage points on average":

Study: Immigration can lower prices of consumer products, EurakAlert: An
important new study examines how immigration influences the prices of consumer
goods. The study, forthcoming in the Journal of Political Economy, challenges
the predictions of the perfectly competitive model – that an increase in demand
leads to higher prices. Instead, the study finds that immigration can lower the
prices of food, clothing, furniture, and appliances and have a significant
moderating effect on inflation.

Immigration to Israel from the Former Soviet Union (FSU) increased
dramatically in 1990, growing from about 1,500 immigrants a month in October
1989 to about 35,000 a month in December 1990.

Using the large variation in the number of new immigrants across Israeli
cities (e.g., some Arab towns reported no new immigrants from the FSU), Saul
Lach (Hebrew University of Jerusalem and the Centre for Economic Policy
Research), compared the relative size of the FSU immigrant population with
monthly, store-level prices for 915 products. These products were sold in more
than 1,800 retail stores in 52 Israeli cities during 1990.

Controlling not only for native population size and overall city size, as
larger cities may have more competitive markets, but also for the effects of
religious holidays on prices during a certain month, Lach finds that a one
percentage point increase in the ratio of immigrants to natives in a city
decreases prices by 0.5 percentage points on average.

In other words, prices in a city with an average proportion of new immigrants
were 2.6 percent lower in December 1990 than in cities where no immigrants
settled.

While the effect was consistent for almost all product categories, Lach found
that the immigration effect was significantly stronger for products for which
FSU immigrants constituted a larger share of the market, such as pork and vodka.

As Lach argues, newly arrived immigrants may be more price sensitive because
of lower income and lack of brand loyalty. Immigrants, who may initially be
unemployed, may also have more time to compare prices, and stores will tend to
lower their prices to attract these new customers. [Saul Lach. “Immigration and
Prices,” Journal of Political Economy, 115:4.]

Tito Boeri and Luigi Guiso discuss Alan Greenspan's role in the housing bubble [more on this topic in the post below this one]:

Subprime crisis: Greenspan’s Legacy, by Tito Boeri and Luigi Guiso, Vox EU: It’s difficult to predict how long the crisis in the world’s financial
markets will last. Its dynamics recalls that of previous crises, such as that of
1998 (the Russian default and the collapse of LTCM), which have by now been
forgotten by many. An excess of liquidity (i.e. an abundance of loans at low
cost) has suddenly been transformed into a dearth of liquidity; many dealers
find it hard to sell the assets in their portfolios. ...

Back to the present

It’s useful to disentangle the causes of the crisis. Three factors contribute
to the current crisis that was triggered by the expectation of defaults on
subprime mortgages in the US.

The low financial literacy of
US households;

The financial innovation that
has resulted in the massive securitisation of illiquid assets, and;

The low interest rate policy
followed by Alan Greenspan’s Fed from 2001 to 2004.

The third cause is by far the most important. Without Greenspan’s policy, the
present crisis probably would have never occurred.

Low Financial Literacy

The first ingredient of the crisis is a blend of bad
information, financial inexperience and myopia of consumers/investors. They fell
for the prospect of getting a mortgage at rates never seen before and then
extrapolating these rates out for thirty years. This myopia was encouraged and
indeed exploited by banks and other lenders eager to attract and retain clients.
This is surprisingly similar to what has been seen in the past when banks and
intermediaries have advised their clients to invest in financial assets
ill-suited to their ability to bear risk. In both cases, a biased advisor is the
reflection of a clear conflict of interest in the financial industry. Financial
literacy is low not only in financially backward countries (as one would
expect), but also in the US. Only two out of three Americans are familiar with
the law of compound interest; less than half know how to measure the effects of
inflation on the costs of indebtedness. Financial literacy is particularly low
among those who have taken out subprime mortgages. The intermediaries exploited
this financial illiteracy.

Securitisation

The second ingredient is the pace of financial innovation
during the last ten years and the securitisation that it produced.
Today it is easy to “liquidify” a portfolio of illiquid credits
(typically a combination of bank loans or mortgages) so they can be packaged
into investor portfolios. Any bank with distressed loans has used
this technique to securitise its own credits. Like all financial innovations,
this too has pros and cons. The advantage is that by making an illiquid credit
liquid, one can achieve important efficiency gains; investors can take
longer-term positions and so earn a higher return. It also spreads the risk of
insolvency across a much wider group, reducing the level of risk exposure of any
individual agent. But securitizations also have their disadvantages. They weaken
the incentives of financial intermediaries to monitor the behavior of the
original borrower. In addition, since a credit that has become risky can be
liquidated more easily, banks have less incentive to screen borrowers carefully.
This opens the credit-markets doors to poor quality borrowers.

Low interest rates

The first two factors aren’t new. Without the third factor – the legacy of
the “central banker of the century” – the crisis probably would have never
occurred.

The post above this one on Greenspan and the subprime crisis reminded me of
this. There seems to be this idea that nobody was warning about the dangers of
the housing bubble before it burst. But some people were. This was Paul Krugman
just under two years ago writing about Greenspan and the bubble:

Regular readers know that I have never forgiven the Federal Reserve chairman
for his role in creating today's budget deficit. In 2001 Mr. Greenspan, a stern
fiscal taskmaster during the Clinton years, gave decisive support to the Bush
administration's irresponsible tax cuts, urging Congress to reduce the federal
government's revenue so that it wouldn't pay off its debt too quickly.

Since then, federal debt has soared. But as far as I can tell, Mr. Greenspan
has never admitted that he gave Congress bad advice. He has, however, gone back
to lecturing us about the evils of deficits.

Now, it seems, he's playing a similar game with regard to the housing bubble.

At the conference, Mr. Greenspan didn't say in plain English that house
prices are way out of line. But he never says things in plain English.

What he did say, after emphasizing the recent economic importance of rising
house prices, was that ''this vast increase in the market value of asset claims
is in part the indirect result of investors accepting lower compensation for
risk. Such an increase in market value is too often viewed by market
participants as structural and permanent.'' And he warned that ''history has not
dealt kindly with the aftermath of protracted periods of low-risk premiums.'' I
believe that translates as ''Beware the bursting bubble.''

But as recently as last October Mr. Greenspan dismissed talk of a housing
bubble: ''While local economies may experience significant speculative price
imbalances, a national severe price distortion seems most unlikely.''

Wait, it gets worse. These days Mr. Greenspan expresses concern about the
financial risks created by ''the prevalence of interest-only loans and the
introduction of more-exotic forms of adjustable-rate mortgages.'' But last year
he encouraged families to take on those very risks, touting the advantages of
adjustable-rate mortgages and declaring that ''American consumers might benefit
if lenders provided greater mortgage product alternatives to the traditional
fixed-rate mortgage.''

If Mr. Greenspan had said two years ago what he's saying now, people might
have borrowed less and bought more wisely. But he didn't, and now it's too late.
There are signs that the housing market either has peaked already or soon will.
And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from
twin imbalances. On one side, domestic spending is swollen by the housing
bubble, which has led both to a huge surge in construction and to high consumer
spending, as people extract equity from their homes. On the other side, we have
a huge trade deficit, which we cover by selling bonds to foreigners. As I like
to say, these days Americans make a living by selling each other houses, paid
for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances.
But if the process doesn't go smoothly -- if, in particular, the housing bubble
bursts before the trade deficit shrinks -- we're going to have an economic
slowdown, and possibly a recession. ...

So there's a rough ride ahead for the U.S. economy. And it's partly Mr.
Greenspan's fault.